Hedge Funds? You're Better Off buying Toto

The reasoning of most lottery players is, “Well, it’s only a couple of bucks.” It’s true that a dollar or two won’t really make a dent in your long-term picture. You will spend more on fancy coffee this morning, surely.

Consider, then, the quandary facing so-called “sophisticated” investors. They put far more than a dollar into the assumptions behind hedge funds. Try “2 and 20” on for size. Hedge fund managers expect investors to pay 2% of assets and 20% of profits, if any.

The “if any” part is the most amusing. As Goldman Sachs recently pointed out in a broad analysis of the industry, just 13% of the funds were beating the S&P 500 in 2012. The point of “hedge” logic is to make money in any market. Except, apparently, a market that mystifies the supposed smartest money on Wall Street.

Try for a moment to picture what 2% and 20% really means. Say you have $1 million under cover. That’s what many hedge funds require of you to invest in the first place. Remember, too, the dreaded “gate” clause. You can’t take money out on a moment’s notice, particularly if the fund is losing ground.

So your $1 million is locked in a safe, for all intents and purposes, and you can’t touch it. So far, that sounds like a certificate of deposit.

Except it’s not. There’s no guaranteed return at all, just your faith that a given manager is going to demolish the benchmark and not be in the 87% group of losers. If that happens, you might think it was a worthwhile gamble. Then the manager comes for his or her piece of the action.

Let’s say your hedge fund returns 10% in a year that the broad stock market turns over, say, 7%. You’re feeling pretty good, right? Now add in the 2% annual fee on assets under management. And the 20% performance fee.

Hedge fund analysis is tricky. The 2-and-20 can vary to as high as 4-and-50 in some cases, but the back-of-the-envelope number works out like this: $1 million plus a 10% return gets you $100,000 in profit for the year.

Subtract the performance fee and you’re down to $80,000. Now take out the annual management fee on your million bucks (the hedge fund gets this win or lose) and you’re out another $20,000. Your take is down to $60,000.

Now picture $1 million sitting in passive ETFs, properly allocated and simply earning their respective benchmarks. It earns 7%. There’s no performance fee and your average cost for the ETFs is not 2% but 0.2%.

On a million bucks, that’s $2,000. Your return for the year is $68,000 — way ahead of the hedge fund holders in a relative “losing” year. You beat the hedgies by 12.5% in dollars returned.

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