September 1


The Hedge Fund Myth


I hope everyone survived the hurricane. We dodged a bullet on that one.

There is a heck of a lot going on in the Kennon household. We have four kids and five pets. It doesn't stay clean all the time, but that's ok. We'll have plenty of time for a clean house once the kids are in college.

The cats' hair is out of control. We have long-haired Ragdoll cats who are 50% fluff and 50% cat. The puppy is nowhere near potty trained (Dad's fault).

The two older boys run cross country, the other runs track, and two take piano lessons. My daughter is in lacrosse and is heavily involved in her high school. My wife is studying to take the unbelievably difficult Series 65 exam required to be a financial advisor. Daddy cares for a puppy at home and runs a highly technical and complex business all week. Whew!

Many of you are asking for more pet pictures, so take a look at the four-month-old cuteness below.

Have you ever heard the term "hedge fund"? Maybe you haven't; if you have, it seems pretty mysterious. Let's dive in and learn more about these garbage investments (you'll see why in a minute).

What is a hedge fund? Generally, a hedge fund is similar to a mutual fund except for a few crucial distinctions.

You have to be an "accredited investor," which means you are worth more than one million dollars.
They are not required to have the same transparency as a mutual fund. They do not have to report nearly as much to the investors.
They use non-traditional investment vehicles such as options, derivatives, currencies, venture capital, private real estate, art, and non-traded assets.
They generally try to be "non-correlated" with the stock market. This means the hedge fund may not decrease as much when the stock market goes down or could even have a positive return.

That all sounds impressive and interesting. It's not fair that only the rich get to invest in hedge funds, right? Not so fast.

Let's take a look at how hedge fund managers get paid. Generally speaking, they use a 2 and 20 model. This means they take 2% of the account value each year and 20% of the profits. As you can see, these costs are incredibly high, many times more than traditional mutual funds. But it's worth it, right? If they can make you more money, who cares what the fees are?

Let's take a closer look. Let's examine a revealing bet Warren Buffett made over a decade ago. In 2008, he bet several hedge fund managers that he could beat their returns (after fees) using a boring old index fund (the S&P 500) over ten years. The bet was for one million dollars.

They combined the five most significant hedge funds to create an overall average return. Warren Buffet put his million in the Vanguard S&P 500 index fund (ticket symbol VOO).

After ten years, in 2018, the hedge funds returned a seemingly impressive 36%. In fact, the hedge funds also showed slightly less volatility versus the overall market. How much did Warren Buffet make on his boring old index fund?


Uh oh. That's not a good look for hedge funds. How could this happen? It was two things. One is fees. Two, the hedge fund managers used exotic investments that were less time-tested.

By the way, I'm not too fond of hedge funds. Why? They prey on the pride and greed of the rich. They are marketed as exclusive, sexy vehicles that someone like you would be lucky to invest in. Go ahead and look at some of their websites. You'd think you were viewing the front page of the Ritz-Carlton or Rolls-Royce.

There are a lot of wealthy hedge fund managers out there. One of them owns the Boston Red Sox. I'm serious.

How do they get away with all of this? There are two ways.

First, no one is tracking their performance. Since they use such non-traditional investments, there is nothing to peg their performance to. How do you know if an 8% return on a venture capital hedge fund is better than the currency markets or private real estate? It's really hard to compare.

If the hedge funds do poorly versus the stock market, they always say, "We are not correlated to the stock market. Over the long term, you will see our value." But people never pay attention over the long term. "Long-term" can mean anything.

Second: They get lucky. What do I mean by this? Let's say ten hedge funds were founded in 2020. In this instance, nine of them do poorly. They may have invested in the wrong kind of asset. They may be grossly incompetent. The funds fold quietly, never to be heard from again. But one of the ten hits it big.

My favorite instance is a few years back when a hedge fund bet that Greek government bonds would decrease in value. Greece's debt did, in fact, almost default, which sent yields soaring. The fund was up 80% in one year. The fund managers yelled from the rooftops of their success. Billions of dollars poured in. The founders got filthy rich with their 2 and 20 models.

Then, over the next couple of years, the fund had well below average-returns. But it didn't matter. Nobody was tracking them versus other investments. The money was already there. The managers were still paid tens of millions for a below-average investment. In other words, they made a huge gamble on their investment strategy and got lucky. It's like they were drilling on new land and hit oil.

So why do people still invest in hedge funds? Warren Buffet proved conclusively that hedge funds will not make you more money. However, new hedge funds are still being created every year. A few months ago, a hedge fund billionaire bought the New York Mets.

Every time I see one of these guys interviewed, they say the exact same thing about their lost bet with Warren. "That was then. This is now. This time is different." (No, it's not.)

But they didn't do anything! Why are we giving them so much credit? They are treated like royalty, like some financial god. All they did was figure out how to collect high fees from many people for doing nothing. They didn't produce a product. They didn't create a valuable service. They sat in their New York offices, watching sports and buying and trading investments. As Warren Buffett says, "It's like they are getting paid to breathe."

Be Blessed,


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