Kurt Brouwer July 28th, 2007
This is an interesting post from Robert Frank at the WSJ’s blog, The Wealth Report, which is devoted to tracking what rich folks do with their money[emphasis added]:
‘For more than six months, I’ve been writing about how the rich are putting less and less money into hedge funds. They could see for themselves — despite constant media reports to the contrary — that returns were slowing while the risks were increasing (along with the fees)…’
‘…And with returns slowing, the investors were getting frustrated paying the “2 and 20″ fees. The only reason they weren’t taking more money out en masse was that many hedge funds had long lock-up periods for investments.
Now we have some new numbers, and they bear out my earlier reporting. According to Cap Gemini and Merrill Lynch’s World Wealth Report, issued Wednesday, the rich cut their exposure dramatically to “alternative investments” — a class that includes hedge funds, private equity, structured products, venture capital and currencies.
In 2005, the world’s financial millionaires (those with investible assets of $1 million or more, not including primary residence) had 20% of their investments in alternatives. In 2006, they cut that exposure in half — to 10%…’
The term hedge fund is a bit confusing to many people because many ‘hedge’ funds take lots of risk and do not seem to balance out the risks they are taking. Yet, the term hedge itself implies the principle of hedging your bet, which means reducing the risk you take.
The original hedge fund started by A.W. Jones almost 60 years ago would be known as a long/short fund today. It bought stocks the manager thought were undervalued, but also balanced or ‘hedged’ that exposure by shorting stocks he did not like. Jones also used leverage or borrowing to accelerate returns. Jones also pioneered the use of incentive fees.
Today, the term hedge fund is primarily a reference to an investment partnership of some type in which the general partner or managing member charges a management fee and an incentive fee or carried interest. This is often 2% as a management fee and 20% as an incentive fee. That’s where the above reference to ‘2 and 20′ comes from.
There is nothing wrong with hedge funds as an investment structure. However, the details are critical. They would have to be carefully-selected both as individual investments and as to their impact on an overall portfolio. In short, they have to make investment sense. The other issue is cost structure in that their cost structure has to be reasonable for what they do. No doubt there are investment firms that can warrant the 2 and 20 cost structure, but that is a high hurdle to overcome.
Apparently, many private investors who jumped on the hedge fund bandwagon have now concluded the same thing.
