It is well documented that hedge funds as a group have underperformed the total stock market over the long run. Yet hedge fund managers are still able to raise large amounts of capital and charge fees of 1-2% plus 20% of the profits. And high net worth investors clamor for access to these investment opportunities. In fact, they are so popular, that most funds can set minimum commitments in the 8-figure range. So an individual high net worth investor can’t even invest in a hedge directly. Which brings us to the Fund of Hedge Funds (FOHF) business model: FOHFs will provide access to a diversified portfolio of hedge fund investments that they personally vetted and selected. And for their services, they will charge a 1% management fee and take another 10% of the profits.
So the individual high net worth investor is now paying 2-3% in management fees plus 30% of the profits for access to a diversified portfolio of hedge funds, which over the long run have underperformed the overall stock market. And that’s before we factor in the shocking tax inefficiency of hedge funds for individual investors. I call it the worst investment vehicle ever. First, the only way to win with alternative investments is to pick the best fund managers. A diversified portfolio of hedge funds will – by definition – deliver the average return, not an exceptional performance. Second, there are plenty of asset allocation firms out there who help individuals build diversified investment portfolios, and they all charge a management fee only, and it is often less than 1%. Why do FOHFs get to charge a higher management fee and take 10% of the profits? It is certainly not because they have demonstrated a track record of always picking top quartile funds (they don’t). It is because they provide access to a market that is otherwise inaccessible. In my view, paying 1%-and-10% for the privilege of being granted access to invest in hedge funds that charge 2%-and-20% is not an attractive investment proposition. However, there is a demand for this access, so I suspect the FOHF business will persist. But I believe the economics of it will decline significantly over time to better align with the value of the service they are providing.
I prefer a different approach: building a globally diversified investment portfolio using academic research to target securities with higher expected returns while minimizing fees and taxes.
