Hedge funds: a market for lemons? - IndependentInvestor.info

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Hedge funds: a market for lemons?

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Are hedge funds a good investment for your typical do-it-yourself investor? Our site has never been particularly supportive of independent investors investing in hedge funds. We apologize for again coming back on this subject from time to time, but we keep coming across more documentation on these wonderful human creations that explain the risks associated with this product. Here are a few examples which recently came across our desk (actually, across our PC).

The basic asset investment categories for all investors are debt and equity securities. Anything else is secondary, and falls in the category called Alternative Investments; for more, see Alternative Investments on our site. Hedge funds as an investment fall in this category.

Hedge funds can be described as follows:

A hedge fund is a private, largely unregulated pool of capital whose managers can buy or sell any assets, make speculative trades on falling as well as rising assets, and participate substantially in profits from money invested. It charges both a performance fee and a management fee. Typically open only to very wealthy qualified investors, hedge fund activity in the public securities markets has grown substantially, accounting for approximately 10% of all U.S. fixed-income security transactions, 35% of U.S. activity in derivatives with investment-grade ratings, 55% of the trading volume for emerging-market bonds, and 30% of equity trades.[citation needed] Hedge funds dominate certain specialty markets such as trading within derivatives with high-yield ratings and distressed debt. Source: definition of hedge funds in Wikipedia. For more, you may consult the full Wikipedia article doc.1038E.

Our site has never been particularly supportive of independent investors investing in hedge funds; see the section Alternative Investments- Hedge Funds . We discussed hedge funds in a previous commentary explaining how sophisticated investors were withdrawing from the hedge fund market; see Hedge Funds in our Archives .
We apologize for again coming back on this subject, but we keep coming across new documentation raising a red flag about this product.

Hedge funds are risky by virtue of the types of investments they make, typically combined with high leverage (high debt levels). Hedge funds are risky for another reason. It is extremely difficult to tell, based on past performance, whether a fund is being run by true financial wizards, by no-talent managers who happen to get lucky or by outright scam artists. If you doubt us, read the newspaper article doc.1037 by Foster and Young from the Brookings Institution; for more, see their complete study doc.1037A, from which the following is drawn.

First, it is extremely difficult for investors to tell whether a given series of excess returns was generated by superior skill, by mere luck, or by duplicity. Second, because it is easy to fake excess returns and earn a lot of money in the process, mediocre managers and con artists could be attracted to the (hedge fund) market. The situation is analogous to an automobile ‘lemons' market with the added feature that ‘lemons' can be manufactured at will Akerlof, 1970). The Hedge Fund Game: Incentives, Excess Returns, and Piggy‐BackingDean P. Foster and H. Peyton Young, November2007, Revised 2 March 2008

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