Do “Shadow" Costs of Hedge Funds Outweigh Any Potential Holy Grail Benefits?

A lot has been written about hedge fund fees and their relatively poor performance (click here for the latest from Warren Buffett), but not much has been written about other “shadow” costs of adding what are often pitched as holy grail like risk reducing and return enhancing investments.

What are the costs of hedge funds that sometimes lurk in the shadows behind impressive presentations?

Some that come easily to mind include:

Lack of Transparency

Not knowing what your manager is really investing in and what risks they might be taking.

Lack of Liquidity

Illiquidity of the product itself or of those non-transparent investments inside the products

Anyone who lived through the 2008/2009 financial crisis should remember that liquidity for opaque investments can dry up quickly when willing buyers on the other side of trades become rare

Inadequate Measures to Evaluate Risk

Given their limited transparency and uncertain liquidity, how can an investor possibly be assessing the risks of alternative strategies accurately?

To these, I would also add two very tangible ones that nonetheless sit often unnoticed because of what I think is an inadequate degree of candid discussion and disclosure:

Taxes

Hedge fund presentations rarely discuss that the majority of returns are often taxed at the highest state and federal tax rates.

Translation: Hedge fund returns can be haircut by 50% for some taxable investors (click here for more on the tax bite of hedge funds).

Fees on Fees of Hedge Funds of Funds

Hedge funds of funds often charge 1% plus 10% of profits over a hurdle rate (sometimes higher).

This is on top of underlying hedge fund fees, which are often 2% plus 20% of profits over a hurdle rate (also, sometimes higher).

Total fees of 3% plus 30% of profits, or more, might be what caused Warren Buffet to recently joke that “Terrible result[s] for hedge fund [investors]” don’t equal “terrible results for hedge fund managers.”

Finally, maybe the cost of untested uncertainty should be added to the mix.

By this I mean that many alternative strategies, especially relatively new “liquid” alts, are being sold based on very complex, hypothetical, multi-factor models. Performance, risk and correlation projections are based on market simulations, where what “should” happen is at best a mathematical hypothesis about - and most definitely not the same thing as - what “will” happen in a real market environment.

As I was reminded by Janet Yellen a few weeks ago when I was fortunate enough to talk briefly with her one-on-one at the Economic Club of New York , “[investment and economic] projections are based on estimates” (yes, estimates on estimates) and that “assessments [about how interest rates, etc. might perform in the future] contain a considerable amount of uncertainty.”

Think about all the potential risks and costs discussed above for a minute: lack of transparency, illiquidity, inadequate risk evaluation mechanisms, models based on estimates, taxes and the potential for high and layered fees.

Might these factors outweigh the allure of “alpha” and the possible benefits of adding complexity in quest of the optimal portfolio?

I am not suggesting that individual, outlier portfolio managers and strategies don’t exist from time to time.

We all want to believe that investment stars in shining risk protection armor will endure, but investors would be wise to reminder that even Camelot didn’t last forever.

History, and a lot of solid research data, teaches us that past performance is very often not indicative of future returns and that even complex models, as impressively as they may seem, often break-down at the wrong time.

As a prime example, during the 2008 / 2009 financial crisis, many asset classes that models said were not highly correlated became highly correlated very quickly on the downside. During the recovery, many so-called diversification investments then provided only limited upside participation.

As fiduciaries on behalf of clients, our families or the trusts, endowments or public funds for which we are trustees, we should be cautious when sales presentations boast too much about the records of investing kings.

Before investing in a hedge fund grail quest, consider the following question:

Does the presentation and presenter of the pitch openly discuss all potential costs?

If issues such as lack of transparency, illiquidity, inadequate risk evaluation mechanisms, taxes, and the potential for layered fees remain in the shadows, beware.

As Pasty reminded King Arthur, Galahad and Lancelot in the sage wisdom that was Monty Python:

“Camelot!”

“Camelot!”

“Camelot!”

[No]

“It’s only a model.”