Hedge Funds? We Don’t Need No Stinkin’ Hedge Funds!

Investing
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By Gary Alt

Learn more about Gary on NerdWallet’s Ask an Advisor

After CalPERS, the largest public pension fund in the U.S., announced this month that it’s selling all 30 hedge funds in its portfolio — about $4 billion — investors might be asking if they should sell their hedge funds. The short answer: yes.

For many years, hedge funds were boutique investments that attracted wealthy and institutional investors by promising higher returns, lower risk, or both, through active trading strategies. A few funds have had outstanding performance, although it’s not clear if this was due to skill or luck.

For some hedge funds, the extraordinary performance may have been because of illegal insider trading, as in the case of Matthew Martoma, who was recently sentenced to nine years in prison for insider trading at SAC Capital Advisors.

But hedge fund investors have had to deal with some serious issues:

  • Hedge funds are expensive. The typical fee annual fee is 1.5% to 2.0% of the investment value plus 20% of the profits, which is significantly higher than the combined cost of paying a wealth manager and the cost of funds.
  • Hedge funds are often not liquid. Many times investors are required to keep their money in the investment for several years. With other funds, in the beginning, you might be able to withdraw money quarterly or annually, but if everyone wants their money at the same time, which is what happened in 2008 and 2009, then liquidity could evaporate, leaving your money locked up indefinitely.
  • Lack of transparency. Unlike mutual funds and exchange-traded funds, hedge funds aren’t required to disclose their holdings, making it difficult to know what is happening with investor money.
  • Some hedge funds are very risky, since they use financial leverage, high-frequency trading and other high-risk techniques. Long-Term Capital Management, a firm started by Nobel Prize winners and Wall Street luminaries, crashed and was bailed out by the Federal Reserve in 1998, then shut down.

But not all hedge fund strategies are high risk. Some of the more conservative strategies try to smooth out market extremes. Morningstar tracks over 1,800 mutual funds and ETFs that use alternative strategies, known as liquid alternatives or “liquid alts.” It’s not surprising that liquid alt funds are one of the fastest-growing categories of mutual funds.

With lower costs, daily liquidity and transparent reporting requirements, mutual funds and ETFs are a better option than hedge funds. Replacing a hedge fund with a liquid alt fund and a portfolio of low-cost index funds will likely produce similar returns at a much lower cost and without the headaches that come with a hedge fund.

CalPERS found that the cost and complexity of hedge funds outweighed the benefits. If the largest public pension fund in the U.S. figured this out, it’s likely that other large investors will follow suit.