If there's a silver lining to the $6 billion in losses that the Amaranth hedge fund tallied up recently, it's that no small investors suffered any crippling losses. That's because hedge funds generally require at least a $1 million initial investment -- and what working Joe with his 401(k) on the line can pony up that kind of dough?
So there were no Enron-style sob scenes to spur mainstream media outrage. That's unfortunate, however, because the Amaranth debacle raises an important question that every investor should consider: What's so great about hedge funds, anyway?
Did you know ...
The party line is that hedge funds earn great returns because they manage risk better and can be more agile in the marketplace than either individual investors or mutual funds can.
But the party line, in this case, may be off base.
A fine article by Jonathan Clements in The Wall Street Journal recently went a long way toward debunking the assumptions of outperformance that have driven the hedge fund craze. And yes, this is a craze. According to a recent report in The Washington Post, hedge fund assets have grown from $5 billion to $100 billion over the past five years.
Citing data from Roger Ibbotson and Peng Chen, Clements shows that the Lipper TASS Hedge Fund Database, which tracks hedge fund returns, may be misleading when it shows hedge funds outperforming the S&P 500 by nearly 5 percentage points per year since 1994 (16.5% versus 11.6%). That's because hedge funds have been known to backfill the database with their good years and because the database may not account for all of the hedge funds that have gone under.
In reality, according to Ibbotson and Chen, hedge funds may have returned a mere 9% per year since 1994 -- trailing the S&P 500.
In a word: Wow
So that's what you get for the $1 million investment minimum and exorbitant fees? Market underperformance? It may be worth noting that any investor can approximate the market's performance for a measly 0.1% per year by buying SPDRs (AMEX:SPY) -- the S&P 500-tracking exchange-traded fund that is broadly diversified among giants such as Citigroup (NYSE:C), Cisco Systems (NASDAQ:CSCO), Intel (NASDAQ:INTC), Altria (NYSE:MO), and Verizon (NYSE:VZ).
That simple solution seems to have bested our revered hedge funds over the past 12 years. Indeed, it's so simple that it prompted Brookings Institution fellow Gregg Easterbrook to tell millionaires, in a recent ESPN.com column, to "just call the 800 numbers of Fidelity, T. Rowe Price (NASDAQ:TROW), or any other reputable public investment firm. You'll get a better deal."
And in most cases, Easterbook is right.
Good advice is easy to follow
Of course, the reason people invest in hedge funds is so they can hire someone else to help them absolutely pummel the market. And that's a noble goal. But hedge fund investors should be aware that it's possible to beat the market without making leveraged bets in volatile commodities markets, as Amaranth did, or, as Amaranth is also reported to have done, putting money behind Spacs and Starts -- business-less entities that (and I'm simplifying here) hedge funds fund in the hopes that they'll someday do something profitable.
Rather, if you're looking for a professional portfolio manager to help you sleep easily and beat the market, we, like Easterbrook, suggest that whether you have $1 million or $100, you stick with boring old mutual funds. But not any mutual fund will do. At our Champion Funds advisory service, Fool fund guru Shannon Zimmerman identifies promising funds by looking for two traits:
- Managers with long tenures and market-beating track records.
- Low expense ratios.
There are other data points to crunch, to be sure, but those two will get you going on the right track. After all, they've worked for Shannon. Unlike the average hedge fund, his picks are beating their relevant benchmarks by more than 7 percentage points to date.
The Foolish bottom line
So if you've got a million dollars ready to plunk down somewhere, maybe it's a badge of honor at cocktail parties to say you're invested in hedge funds. Just know you may not be getting the market outperformance you think you are.
If, on the other hand, you're simply looking for your money to grow for years and years and years, why not take a look at our Champion Funds recommendations? There's no obligation to subscribe, and some of our funds will let you get going with as little as a few hundred dollars. Click here for more information.
Tim Hanson does not own shares of any company mentioned. Intel is a Motley Fool Inside Value recommendation.The Fool's disclosure policy assures you that no stocks were harmed in the writing of this article.
