Hedge funds: 6 investment concerns you shouldn't ignore

One by-product of a low interest rate environment is that investors may turn to alternative investments like hedge funds in a desperate search for better results. This includes both individuals and some major institutional investors. As seductive as the possibility of higher returns might be, most investors would do well to ignore the siren song of hedge funds.

The hedge fund industry got a huge black eye a few years ago from the Bernie Madoff scandal. But even short of actual wrongdoing, hedge funds often suffer from important conceptual flaws.

Here are six things you need to watch out for if you are contemplating hedge fund investments:

1. Hedge funds may not have risk protection

To begin with, the term "hedge fund" is often misleading. Hedging is supposed to involve some sort of risk protection, such as offsetting long and short investments. The reality is that in many cases hedge funds do not involve any sort of hedge that will counteract negative developments with positive returns. Instead, they often involve leverage in the form of options or the investments on margin.

This is the opposite of hedging, and can result in exaggerated losses. So, despite the name, when people invest in hedge funds, they should not assume that the investment represents a hedge against risk.

2. Be wary of return assumptions

One of the reasons why pension plans are interested in hedge funds these days is that they are under pressure to earn returns that will match or exceed their actuarial funding assumptions. Pension plans are funded on the assumption that they will earn at least a given rate of return, often in the neighborhood of 7.5 percent. If returns are lower, the plan sponsor has to contribute more money to the plan.

A 7.5 percent return assumption is a bit of a stretch at a time when money market rates are near zero, and Treasury bonds are yielding less than 3 percent. Plan sponsors can justify keeping their return assumptions high if they invest in alternative investments which theoretically might produce larger returns. However, this means basing return assumptions on what plan sponsors hope will happen, not what will probably happen.

If returns disappoint, using hedge funds to justify unrealistically high return assumptions will result in these pensions being seriously underfunded.

3. Data provided may not represent all funds' performance

A reason people are willing to believe in the return potential of hedge funds is that consultants promulgate databases that can inflate the average returns earned by these vehicles. Those databases can have a survivor bias - they consist of funds which are still around. As a result, the weakest-performing funds that went out of business are not represented in the average results.

In fact, many databases consist only of results that investment managers choose to report so they tend to represent the best-performing products investment managers have to offer at the time. However, the reports do not feature a full cross-section of how those managers actually did across the full product line.

4. Funds have limited liquidity

Another reason to take hedge fund performance with a grain of salt is the limited liquidity both the hedge funds themselves and their underlying investments often have. This means that stated prices might not reflect the actual value you could get from the investment if you tried to sell it.

Limited liquidity is especially problematic for hedge funds that have experienced rapid growth. Investment strategies that worked with a few million under management might not be viable with a few billion under management.

5. Performance may not meet typical results

Hedge funds are often presented as a distinct asset class. However, because of the amount of latitude they give their managers, their investment composition - and thus their results - tend to be very idiosyncratic. These are not good investments for someone constructing an investment program on the assumption that each asset class represented in the portfolio will perform reasonably closely to a corresponding market index.

6. The odds are against earning above-average returns

The fee structure of hedge funds really stacks the odds against success. The industry standard is a 2 percent annual management fee, plus profit participation through which the manager gets to keep 20 percent of any investment earnings.

This means a hedge fund has to have extraordinary returns in order for investors to do well after paying 2 percent plus 20 percent of the profits.

Hedge funds can give investment managers a degree of latitude they would not have with mutual funds. However, before you invest in a hedge fund, you have to decide whether the manager is going to use that latitude for your benefit or their own.

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