Hedge Funds Overcharge and Underperform

Hedge funds – those special places for the very rich – do a fantastic job of enriching their founders. Unfortunately, their investors would be better off in an S&P 500 index fund. Based on 2010’s performance, hedge funds have much higher fees and generate returns that are slightly more than half those of the average stock.

For example, according to Bloomberg, hedge funds rose 7% in 2010, while the S&P 500 was up 13%. Meanwhile, those hedge funds charge investors a 2% management fee and 20% of the profits. This compares to a sub 1% expense ratio for the typical S&P 500 index fund. So why do the wealthiest people invest in hedge funds? Maybe they’re smarter when it comes to making money than they are when investing it.

The performance of the hedge funds in 2010 was not monolithic. Some investment strategies performed better than others, according to Bloomberg. Here are five examples:

• Mortgage securities funds that seek to profit from price inefficiencies of mortgage securities were up 24% in 2010.
• Short funds (sell shares short): +7.5%
• Multi-strategy funds (use many strategies): +2.9%
• Macro funds (global themes or trends): +2.2%
• Statistical equity arbitrage (using quantitative analysis to find small profit opportunities): +0.4%

Compared to this mediocre performance, the compensation of the hedge fund managers is absolutely breathtaking. Here's how much the top five made in 2009 (the most recent information available) along with their funds' 2010 returns of their top-performing fund from Bloomberg Markets:

• David Tepper ($4 billion, 20%)
• George Soros ($3.3 billion, not available)
• James Simons ($2.5 billion, 15.9%)
• John Paulson ($2.3 billion, 16.9%)
• Steve Cohen ($1.5 billion, 11%)

To be fair, these managers out-performed their peers by a long shot. But if 2010's performance is any indication, they missed the boat and their investors would have been better off putting their money in an S&P 500 index fund.

I hope they have better luck in 2011 but I would bet the only ones really making out are the fund managers.