For a long time I have wondered to myself why so much supposedly “smart money” was invested in hedge funds:
outrageously expensive, opaque management, selective reporting of long-term investment results, often illiquid, the list could go on.
Not exactly my idea of a responsible home for the life savings of thoughtful responsible investors.
Well, the other day while I was catching up on some reading, I came upon this dead on quote from none other than Eugene Fama, 2013 Nobel laureate in economic sciences and widely regarded as “The Father of Modern Finance” – also one of the leading academic minds behind the enormous success of Dimensional Fund Advisors - in a brief piece he wrote titled “On hedge funds.”
“If you want to get poor quickly, you should go into them. If you believe the arithmetic of active management, why would you pay 2-and-20[2 percent of total asset value, 20 percent of any profits]?
I’ve never been able to explain why these things exist. They demonstrate, absolutely, the phenomenon of money moving quickly based on noise….You expect extreme returns, one way or the other. After you take off the 2-and-20 you expected, on average, you’re going to be down. Because hedge funds are subject to the arithmetic of active management, they’re part of that game.”
Let me just quickly explain a couple of Dr. Fama’s references. “Arithmetic of active management” means that all the aggregate trading done by participants in financial markets creates the performance of the total market thus when expenses are introduced, the average return must be below the market’s return by just this amount. His “noise” reference alludes to the constant buying and selling of securities based on random unpredictable short-term events that have nothing to do with the fundamental economics of expected long-term results. But even if I’ve done a lousy job explaining these two ideas, don’t worry, you needn’t go any further than Dr. Fama’s first sentence, “If you want to get poor quickly, you should go into them” and third sentence “I’ve never been able to explain why these things exist.” as the combination says it all.
Dr. Fama is brilliant yet his candor and unceasing ability to deliver huge messages clearly and succinctly is priceless (thanks for that one Mastercard ). Anyways, this huge message about the folly of hedge funds is one that we all must never forget, especially for those of us residing in New York and Connecticut and Florida where talk of them is often so front and center.
If I have piqued anyone’s interest and you’d like to delve into this subject further one-on-one I’ll be happy to carry on but for now just remember when it comes to hedge fund investing, you have every reason in the world to be afraid, very afraid, and if someone should try to pitch one to you or a loved one, flee to safety just as fast as you can.
