Thinking Of Investing With A Hedge Fund? Consider These ETFs Instead

Includes: HUSE, RALS, XLU, XLV
by: Joseph L. Shaefer

If you're ready to hand over your wallet to a hedge fund, I have three words of advice: "Don't do it!" I have written frequently about their exorbitant fees, their hundreds of millions spent stuffing cash in politicians' campaign funds (er, "lobbying") and, most of all, their failure to provide good value in return.

Now others seem to be joining in sounding this alert. Mark Hulbert, the investment letter cheerleader/critic, in an article this summer, "The Verdict is In: Hedge Funds Aren't Worth the Money" reaches the same conclusions. He writes, "Hedge funds supposedly pursue complicated strategies that do well whether markets are going up or down.

"Yet the average hedge fund has done no better than the stock market since the October 2007 bull-market high. The Dow Jones Credit Suisse Hedge Fund index, encompassing nearly 8,000 [hedge] funds, produced a 3.3% annualized gain over this period, versus 3.4% for the Wilshire 5000 Total Market index, which reflects all U.S. stocks, including dividends.

"...A fairer comparison might be with all mutual funds and [ETFs], regardless of investment focus. According to Lipper, the average annualized return of all funds it follows was 5% from October 2007 through the end of April- 1.7 percentage points a year higher than the average hedge fund.

"… Since Oct 2007, a portfolio invested 60% in a stock-market index fund and 40% in a bond index fund has beaten the average hedge fund by 1.9 percentage point a year, with no more downside risk or volatility…"

Of course, averages conceal a lot of over- and under-performance at the tails of a normal probability distribution. So you might say, "Well, sure, there are a lot of also-rans out there, but my hedge fund guru is one of those geniuses 5 standard deviations to the right of the mode/median/mean."

Oh, really? And in a business with virtually no transparency but much gobbledy-gook about quantitative analysis and black boxes, how do you "know" they are a genius? Because of their past performance? Tell that to the investors in Long-Term Capital Management, whose masterminds included founder John Meriwether, former head of bond trading at Salomon Brothers, Directors Myron Scholes and Robert Merton, 1997 Nobel Prize winners in economics, and former Vice Chairman of the Federal Reserve David Mullins Jr. After these and their other MBAs and PhDs had a couple fabulous years, in 1998 they went so spectacularly bust that the Fed, to prevent investor panic, hastily created a bailout plan.

Thousands of investors may have gone broke , but don't shed a tear for the LTCM principals. After having left Solly under a cloud for trading irregularities, Mr. Meriwether founded LTCM. After losing everything for investors in LTCM, he founded JWM Partners the very next year. Gullible investors lined up and he had $3 billion under management by 2007, when he lost investors 44% and closed the fund. He is now running his third hedge fund, JM Advisors. (Of course, these gentlemen were paid 2-and-20 for every good year and 2-and-zero for every bad year. The investors were left with massive losses and the hedge fund managers were left with 20% of all the profits for all those preceding good - or lucky - years.)

Lest you think Mr. Meriwether is unusual, his was just the first of many massive hedge funds that attracted billions, then lost everything for their investors. Many now do "good works," as long as there's a tax deduction in it for them, and are lauded by those who don't know or care how they made their money.

Here are a couple more to jog your memory: Julian Robertson's Tiger Funds were devastated in 2000. Both Aman Capital and Marin Capital sank beneath the seas in 2005. Amaranth Capital lost $5 billion in a single week in 2006. We still don't know the extent of the losses at John Corzine's MF Global; the latest estimates are approaching $2 billion. All these were seen as geniuses with a Midas touch when their just-passed couple of years attracted billions. Then there are the more recently feted geniuses like John Paulson, the 28th richest American, who did splendidly from 2007 to 2011, in which year his flagship fund went on to lose 40% for investors. (And an additional $700 million in the just-passed 2nd quarter of this year.) Before you heed this Siren's call, remember, a 60/40 index fund split beats hedge funds!

Hedge funds take such massive risks because it pays well to do so. It may not benefit their investors but it lets their managers, to note but one example, buy a string of thoroughbreds, a $30 million place in Aspen, another in Southampton, another on Lanai, and of course a little 28,000 square-foot pied-a-terre on the upper East Side - even if investors lose everything. Until we can get Congress to close the carried interest loophole, this kind of insane trading will continue. Worse, their every move will be lionized.

The rise of the Internet has coincided with the failure of financial journalism. Something appearing on a blog written by some nut-case living in Mama's basement gets picked up by once-responsible news organizations and passed along as if it were fact. Then it gets picked up by others citing the better-known news organization as the source. Many an investor has made intelligent, well-researched decisions only to see them dashed by something Soros or Einhorn or Paulson say. Though not necessarily what they do. Many times, they've used the bully pulpit of television and other media to tell others what to do. (Of course, talking up the stocks they own only to sell into the resulting buying frenzy is not unique to hedge funds; Wall Street has been playing that game for more than 100 years…)

If you really want a "hedge" in the market, may I suggest you consider going long one sector you believe will perform best and short a different sector you see as a laggard? You could simply buy, say, the SPDR Health Care ETF (NYSEARCA:XLV) and sell short, say, the Utilities sector (NYSEARCA:XLU). Or you could select one of the many long/short mutual funds or ETFs. In the latter category, I particularly like the ProShares RAFI Long/Short ETF (NYSEARCA:RALS). And if you seek something that provides sector rotation for you when conditions change, you might take a look at the Huntington US Equity Rotation Strategy ETF (NYSEARCA:HUSE), which does that work for you.

Hedge funds absolutely create wealth - for their managers. Do it yourself and create wealth for... yourself.

THE FINE PRINT: As Registered Investment Advisors, we see it as our responsibility to advise the following: we do not know your personal financial situation, so the information contained in this communiqué represents the opinions of the staff of Stanford Wealth Management, and should not be construed as personalized investment advice.

Past performance is no guarantee of future results, rather an obvious statement but clearly too often unheeded judging by the number of investors who buy the current #1 mutual fund only to watch it plummet next month.

We encourage you to do your own research on individual issues we recommend for your analysis to see if they might be of value in your own investing. We take our responsibility to proffer intelligent commentary seriously, but it should not be assumed that investing in any securities we are investing in will always be profitable. We do our best to get it right, and we "eat our own cooking," but we could be wrong, hence our full disclosure as to whether we own or are buying the investments we write about.

Disclosure: I am long RALS, HUSE, XLY, XLE, XLV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.