What is The Optimal Allocation to Hedge Funds As Part of Your Portfolio ? Answer = ZERO

I always calculated, based on simple arithmetic, that the numbers were rigged against investors in hedge funds. But an article in the March 4 NYT highlighted academic research that has reached the same conclusion. The fee structure of 2% annual fee + 20% of profits makes it virtually impossible for the investor to do better than simply putting the money into a simple index fund.:

MANY people would jump at the chance to invest in hedge funds, which have mainly been available to only the very wealthy. But a new study finds that the funds’ high fees make it unlikely that investors will improve their long-term performance by putting money into hedge funds.

The study, “Portfolio Efficiency With Performance Fees,” was written by Mark Kritzman, president and chief executive of Windham Capital Management, a money management firm in Boston. appeared in the Feb. 1 issue of Economics and Portfolio Strategy, a newsletter for institutional investors, published by Peter L. Bernstein.

Mr. Kritzman’s article focuses on the effect of the fees that hedge funds charge.

You can follow the link to the article and get the details of the study, but here is the bottom line ..

…..the fees’ effect on the portfolio was so sizable because of the “asymmetry penalty” resulting from the 20 percent cut of profits that the hedge funds earn. The funds do not share in investor losses — but they reap a large share of the profits.

To illustrate how these fees can add up, Mr. Kritzman conducted another experiment. He tried to determine how much a rational investor should allocate to this hypothetical portfolio of 10 hedge funds, when also given the opportunity to invest in a stock index fund and a bond index fund…..

Mr. Kritzman found that, given these assumptions, the investor should allocate nothing to the basket of hedge funds and everything to the two index funds…..

What about so-called funds of hedge funds, which have lower minimums and are therefore available to less-affluent investors? Mr. Kritzman says he finds it difficult to justify any allocation to funds of hedge funds, because they earn fees above and beyond those earned by the hedge funds in which they invest, typically 1 percent of funds under management and 10 percent of profits above a benchmark.

The bottom line, Mr. Kritzman said, is this: “Because of fees, the optimal allocation to a group of hedge funds is a lot lower than you might think it should be.”

In fact the bottom line is even worse. Kritzman’s calculations were based on pre tax returns. Hedge funds generally use “mark to market” accounting which means that all gains are treated as short term income which is taxed at the ordinary income rate of up to 35%, reducing the after tax return for most hedge fund investors by that amount.