The Promise of Alternative Investments

The many proponents of alternative investments such as hedge funds, private equity, real estate etc. are promising higher returns, lower correlations and lower volatility of returns.At least, that's what I learned when I took the CAIA course back in 2007. Four years have passed, and I wonder whether those wonderful promises are being fulfilled.

Meanwhile I came across some rather skeptical observations by some investment professionals about hedge funds, the biggest of all alternvative asset classes.

Warren Buffet stated that hedge fund fees (2/20 fee structure) are ensuring that investor as a whole underperform with hedge funds.

Prof. Allan Roth of the University of Colorado wrote in his blog: 

• Too expensive: while mutual funds already earn 1-2% p.a. (for underperforming the market) hedge fund earn 2/20, but often investors hold fund of funds with 2 layers of 2/20!

• Encourage risk: 2/20 encourage managers to take excessive risks. If they win they earn big, if they loose they close the fund, and start a new one. 
• Risky hedge funds attract most money: advisors generally select funds with the best past performance, i.e. the risky ones who were lucky. Those are the most likely to blow up in the future (when luck runs out, and leverage kicks in on the down side).
• Inefficiencies reduced: Most hedge funds follow the strategy of pursuing market inefficiencies. Unfortunately, big capital inflows are chasing the same inefficiencies, diminishing opportunities.
• Lack of liquidity: Many hedge funds do not provide the possibility of liquidating your holdings in a few days.
  
• Lack of transparency: Hedge funds are generally intransparent regarding their holdings and details of their investment strategy claiming that they need to protect their secret of success. Unfortunately, this opens the door for fraudsters like Bernie Madoff.

Average hedge fund manager receiving fees

We can argue all day long, but without any evidence we are not really smarter.

Luckily a consulting firm analyzed statistical data of Swiss pension funds for the Swiss federal department of social insurance in a extensive study. Bottom line:

1. The bigger the hedge fund share the higher the pension funds management costs.
2. The average allocation to hedge funds of 6% of total assets are causing a third of total management costs.
3. The bigger the hedge fund share the lower the overall return on investments. 

To sum up, on average hedge funds are enriching their managers and not the investors.

At last, I want to point on the economic role of investors: Their function is to provide efficiently capital to the economy in the long term, and not chasing short term gains. In contrast, the classic value investor is fulfilling this role and he outperforms long term.