Wall Street has always tried to woo would-be clients with the promise of exclusive access to moneymaking investments that ordinary investors can't buy. Now that the Securities and Exchange Commission has removed restrictions on private offerings that have been in place for eight decades, the door is open for hedge funds and other high-end investment vehicles to ramp up their solicitation of new business.
Given the amount of money involved, you can expect hedge funds to jump on the opportunity. But most investors should simply ignore new hedge-fund ads, for a variety of different reasons. Let's take a look at three of them.
1. Hedge funds can't take average investors' money.
Even though the SEC lifted restrictions on advertising, the limitations on who can actually invest in a hedge fund or other private offering remain fully in force. In particular, in order to participate in a hedge fund, you have to qualify as what the SEC calls an accredited investor. Currently, the SEC defines an accredited investor as someone who has a net worth, either individually or combined with a spouse, of $1 million excluding the value of any primary residence the investor owns. Alternatively, you can qualify as an accredited investor if you have individual income of $200,000 or more or joint income with a spouse of $300,000 in each of the past two years, and you reasonably expect to have the same level of income in the current year as well.
A proposal several years ago sought to increase the accredited investor standard to $2.5 million in net worth, but it never took effect. Nevertheless, the accredited investor standard serves to exclude most investors from hedge-fund eligibility, as 95% of tax returns in the IRS' latest data had incomes below $200,000, and millionaires make up about 9 million U.S. households.
2. Hedge fund performance has been weak lately.
Inevitably, hedge funds will tout whatever performance numbers put them in the best light. But at least recently, they haven't been able to deliver an advantage over less exclusive investment vehicles. According to Bianco Research, one popular index of hedge fund performance has underperformed the universally investable SPDR S&P 500 ETF (SPY 1.19%) by 50 percentage points since the end of 2010. High-profile hedge funds like John Paulson's gold fund have been in the news lately because of their massive losses that haven't compared favorably to bullion ETF SPDR Gold (GLD -0.25%) or to the mining-company ETF Market Vectors Gold Miners (GDX 1.60%).
Of course, some hedge funds have outperformed their benchmarks as well. But unless you're confident that you can weed out the losers from the winners, you can find plenty of mainstream investments that will give you similar exposure to what many hedge funds offer. If hedge funds can't consistently deliver guaranteed superior returns -- and they can't -- then it takes away most of the incentive to buy them.
3. Hedge funds are ridiculously expensive.
The infamous 2-and-20 guidelines for hedge-fund fees represent the excessive share of profits that managers take. Annual expenses of 2% off the top are bad enough by themselves, but taking away another 20% of any gross positive returns that the fund's investments generate adds insult to injury. If a hedge fund only managed to match the broader stock market's gains of about 15% this year, it would still take 5% of its investors' money in fees -- compared to less than 0.1% for the S&P 500 ETF, 0.4% for the SPDR Gold ETF, and 0.52% for the Market Vectors ETF.
Give hedge-fund ads a miss
You probably won't be able to avoid seeing hedge-fund advertising, but don't fall for the siren song of its promises of exclusivity and performance. You can put together a completely successful investment portfolio without having to jump through all the hoops and hoopla involved with hedge funds, and with just a little effort, it'll cost you a whole lot less to do so.
Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter @DanCaplinger.
