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Why hedge funds are not the best choice for investors

28 August 2018 Steven Nathan, 10X Investments
Steven Nathan, the CEO of 10X Investments.

Steven Nathan, the CEO of 10X Investments.

Few topics get fund managers more emotional than investment fees. Few things destroy your retirement fund more than high investment fees. Few topics generate more interest than fund manager performance – or lack thereof. Combining high fees with poor performance is bound to spark even more interest and debate.

“These issues were highlighted recently when the fund manager, Sygnia, announced that it was shutting down its hedge fund of funds after 13 years,” says Steven Nathan, the CEO of 10X Investments. Sygnia sold hedge fund of funds, which is a fund that invests in other hedge funds. “The concern with this type of product is that it involves adding additional layers of fees to an already expensive product,” Nathan explains.

Hedge funds operate differently from the more commonly known investment types such as unit trusts and pension funds. While those investment types generally invest in shares in listed companies, in properties, bonds and in cash, hedge funds apply investment strategies that are more technical in nature. They change the nature and the risk of an investment portfolio.

Nathan cautions investors about the claims made by hedge funds regarding their outperformance against their benchmarks. “Typically, a South African equity investment portfolio would benchmark itself against the JSE All Share Index, and so the portfolio will measure its performance in relation to the JSE’s performance. But, hedge funds tend to opt for a benchmark that favours them, such as cash, which generally performs worse than equities, which means that, when they outperform whatever the benchmark is, it may be the result of poor performance by that benchmark, rather than the skill of the fund manager.”

Nathan adds that it is crucial that investors take into account the fees charged on investments.

“In addition to a management fee of at least 1%, hedge funds also levy a performance fee,” Nathan explains. “And then, if it is hedge fund of funds, this adds another layer of fees. Also, hedge funds tend to trade more than traditional funds, which adds to the costs of the trading.”

The bottom line is that fees for hedge funds and hedge fund of funds can really add up. For example, the Sygnia All Star Hedge Fund of Funds had a 7.5% total expense ratio in September 2016.

Nathan says: “By any reasonable measure, a 7.5% fee is outrageous and qualifies for the title of fee-fleecing. This fund returned -2.4% in the prior 12 months, so while investors lost money, the HF and investment industry (with trading costs) earned R7.5 million for every R100 million invested.

Warren Buffett is a long-time critic of active managers and hedge funds. Buffett’s central thesis is that the high costs associated with active management detract substantially from long run investment returns without, in aggregate, adding any value overall.

In 2007, Buffett placed a $1 million bet to prove his point. He bet that over the next 10 years, an S&P500 index fund would beat five hedge funds of funds. In the following 10 years, the S&P Index fund gained 125.8% versus 36.3% for the hedge funds of funds. Not even the best performing hedge fund of funds came close to the index fund over 10 years.

While some hedge funds have produced attractive returns, the majority have not. In addition, their fee structures reflect that the beneficiaries are the fund managers but not their clients. As Warren Buffett has said: “When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.

“For me that says all you need to know,” Nathan concludes.

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