Should Hedge Funds Be Avoided?

Hedge funds over the first three months of 2016 suffered their worst quarter in seven years. That prompted investors to withdraw a whopping $15 billion from hedge fund investments, according to a recent report.

The reason why investors are fleeing these supposedly elite investment vehicles for the ultra-rich and sophisticated is simple: they’re fed up with paying exorbitant fees for underperformance.

Hedge funds typically charge a 2% management fee and 20% of the profits. Apparently, investors are balking.

Regular readers of this blog know that the hedge fund industry is suffering. As we pointed out in April, the Department of Labor’s new fiduciary rule, which applies to 401(k) and retirement accounts, should prove an effective road block to keeping high risk hedge funds far away from employee retirement plans.

And recent poor performance of hedge funds has pushed some of the industry’s biggest investors, defined benefit pension plans who oversee billions of dollars of retirement plans, into dumping hedge funds all together.

With the industry already in trouble, top U.S. securities regulators are shining a bright light on hedge fund leverage. Leverage, or massive borrowing, is the tool that greases the hedge fund wheels. Hedge fund managers use leverage, or borrowed capital, to increase the potential returns on their high risk bets.

A recently released report by the U.S. Financial Stability Oversight Council sounded an alarm about how hedge fund leverage could contribute to financial stability risks.

According to industry trade newspaper InvestmentNews, “The Financial Stability Oversight Council released a preliminary report on its two-year review of the asset management industry, citing concerns about liquidity at mutual funds and leverage in hedge funds.

“FSOC, which was created by the Dodd-Frank Act, also showed concern about the high use of leverage by hedge funds, according to InvestmentNews. ‘Leverage is not a perfect proxy for risk, but there is ample evidence that the use of leverage, in combination with other factors, can contribute to risks to financial stability, the report noted.

“While smaller hedge funds tend to use leverage sparingly, the largest hedge funds tend to use large amounts of borrowed money for their transactions, FSOC noted. While many of the funds’ leveraged positions tend to be hedged, the report notes that it needs more data to assess the risks. The main worry: A highly leveraged hedge fund could have difficulty unwinding assets in a crisis.”

Sound familiar?

When hedge fund managers’ bets go bad, it can spell trouble for the entire economy. Remember the havoc caused by the 1998 collapse of the giant hedge fund Long-Term Capital Management? Or how about the 2007 implosion of two Bear Stearns hedge funds, which invested in subprime mortgages, and preceded the Great Recession?

Wall Street doesn’t learn.

Despite the clarion calls and clear dangers of hedge funds, UBS, a leading manager of retail investor assets, actually “boosted its recommended allocation to hedge funds for the second time in as many years, saying the strategy will provide stability amid volatile markets,” according to a Bloomberg report from April.

UBS prefers to recommend to its customers that they buy hedge funds rather than bonds because they “offer a more attractive risk and return trade-off than bonds,” according to Bloomberg, citing a UBS report from March.

Investment fraud attorneys may be getting lots of calls soon from burned investors.

As Yogi Berra once famously stated, “It’s like déjà vu all over again.”

Yes it is, Yogi. Let’s just hope the next hedge fund crash fails to set off a widespread disaster.

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