Pity the Rich Investing in Hedge Funds. Seriously.

Rich Smith
Updated
<b class="credit">Akos Stiller, Bloomberg via Getty Images</b> George Soros, founder of Soros Fund Management.
Akos Stiller, Bloomberg via Getty Images George Soros, founder of Soros Fund Management.

Hedge funds. Everyone wants to invest in them, but if you want to get into one, you generally have to meet either one of two conditions, laid down by the Securities and Exchange Commission: Either you must earn $200,000 or more a year, or you must have net worth of more than $1 million.

That exclusivity has helped fuel explosive growth in America's hedge fund industry, which has expanded from $300 billion in assets under management 15 years ago, to $2.2 trillion today. Clearly, this is a popular investment party -- one that (statistically speaking) you probably aren't invited to.

Oh, the Unfairness of It All

At first glance, it seems unfair that average people can't invest in the rich-folk hedge funds. And, as explained in a recent article in The Wall Street Journal's WSJ.Money magazine, it is unfair ... not to us ordinary investors, but to the rich folks whose hedge fund investments consistently underperform the stock market.

How unfair is it? Here are a few facts and figures to draw you a picture:

  • The average hedge fund charges its clients 2 percent of whatever money they invest with it -- payable every year. Plus, if the hedge fund makes a profit, the manager skims 20 percent off the top of this profit. (Conversely, when a hedge fund loses money, the manager does not give money back to investors.) What it all works out to is that your average hedge fund manager has to earn 12 percent per year in profit in order for his clients to just match the 8 percent long-term average return they could get on a plain vanilla S&P 500 index fund.

  • That's not easy to do, and in fact, according to Hedge Fund Research (HFR), the average hedge fund does not outperform the market. Rather, over the past three- and 10-year terms, the average hedge fund underperformed it. Over longer periods of time, the results have been similarly bleak. A 2009 study conducted by Emory University and Harvard Business School determined that the average hedge fund investor earned just 6 percent annually on his investments.

  • What's worse, funds making it into HFR's underperformance study only included those funds still alive at the end of the study. Factor in the total losses of hedge funds that have gone bust, and the underperformance would look even worse.


So to answer the perennial question: Is the system for investing in hedge funds unfair?

Yes. It's unfair to rich folk.

Motley Fool contributor Rich Smith once considered investing in a hedge fund, but decided against it. Now you know why.

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