Farrell: Beware overtures from hedge funds

Hold on to your wallet. That’s my reaction to the news that the Securities and Exchange Commission has lifted a ban on hedge funds advertising publicly for the first time. Bloomberg Businessweek put it even more bluntly with its recent cover story, “Hedge Funds Are For Suckers.”

A hedge fund is a lightly regulated investment vehicle that caters to (supposedly) sophisticated institutional investors and high-net-worth individuals. These partnerships traditionally tried to preserve wealth in good and bad markets. The term hedge fund comes from the phrase “hedging your bets.”

That was the approach of Alfred Winslow Jones, the sociologist-turned-journalist-turned-money-manager who pioneered the modern hedge fund in 1949. A hallmark of hedge funds is complex investing strategies, such as the extensive use of leverage and derivatives. Most hedge funds charge a management fee of 2 percent of assets plus 20 percent of profit.

The industry moved away from a focus on preserving wealth in the 1980s and hedge funds became famous for making aggressive bets. Hedge fund money managers include many of the best-known billionaire gunslingers on Wall Street. To invest in a hedge fund signaled membership in an exclusive club. Even with the lifting of the advertising ban you’ll still need substantial resources for entry.

“Hedge funds became symbols of the richest and the best,” writes Roger Lowenstein in “When Genius Failed: The Rise and Fall of Long-Term ­Capital Management.’’

Hedge fund operators have reserved for themselves the lion’s share of the profits. The trend is prompting investors to again pose one of the most famous questions on Wall Street: “Where are the customers’ yachts?”

The question comes from a brilliant 1940 book about Wall Street by Fred Schwed Jr. “Where are the Customers’ Yachts” begins with an allegory. “Once in the dear dead days beyond recall, an out-of-town visitor was being shown the wonders of the New York financial district. When the party arrived at the Battery, one of his guides indicated some handsome ships riding at anchor.

“He said, ‘Look, those are the bankers’ and brokers’ yachts.’

“ ‘Where are the customers’ yachts?’ asked the naive visitor.”

Where indeed, people seem to be wondering. The industry’s track record is faltering. When it comes to investing it appears to be far more rewarding to be dull, boring and prudent, say, stashing money in plain-vanilla equity index funds.

The S&P 500 stock market index outperformed a major hedge fund index from 2002 to 2012. The Economist magazine offers this sobering calculation: “A simple-minded investment portfolio — 60 percent of it in shares stocks and the rest in sovereign bonds — has delivered returns of more than 90 percent over the past decade, compared with a meager 17 percent after fees for hedge funds.” Ouch.

There is a time-honored investment rhythm on Wall Street that success eventually breeds excess. The current hedge fund industry is no different. Too many people have flocked into the business. Hedge fund assets have grown from less than $40 billion in 1990 to $2.3 trillion today, managed by 10,000 hedge funds. So many investment gunslingers have joined the business that market-beating returns are harder to earn. Some hedge fund managers will still do well, of course. But the performance of the average fund is likely to disappoint with too much money in too many funds.

So, for anyone who qualifies, if you receive marketing materials from a hedge fund, remember the adage, “Where are the customers’ yachts?” This is a club most people won’t want to join. There are better ways to put your money to work.

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Chris Farrell is economics editor for “Marketplace Money.” His e-mail is cfarrell@mpr.org.

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