In popular culture, hedge funds often get portrayed as the Holy Grail of investing. They are these secretive, exclusive, and not-well-understood entities that can invest better than anyone or anything else. If you invest in a hedge fund, you are on the inside — and you get incredible returns. Returns that just aren’t available to the average investor. At least that’s what it seems like.
But is this really the case? What does the data say? As it turns out, there are some pretty big problems with hedge funds.
So, let’s look a little bit deeper, and examine why these are particularly problematic investments for physicians.
What Are Hedge Funds?
Seems like a silly question because pretty much all of us have heard of a hedge fund. But honestly, I couldn’t give you a definition as of a couple days ago.
Basically, hedge funds are composed of pooled money from many private investors. They are generally managed by an active manager. And they use more risky and complex investing strategies — like using leverage to investing in non-traditional assets — all with the goal of achieving higher-than-usual returns. Never mind that they also generally carry much higher fees and minimum investment limits.
But the important thing to understand here is that, at their core, hedge funds are designed to improve returns.
Do Hedge Funds Actually Improve Returns?
Thankfully, tons of studies have examined this very question.
Here are some of them (referenced in the book “The Quest for Alpha” by Larry Swedroe):
- A 1999 academic study found that most hedge funds underperformed the S&P 500 index.
- A 1999 Forbes article examined the performance index of 2,600 domestic and international hedge funds from 1993 to 1998. The author found that the average annualized return of these funds was 13.4% after fees. This trailed the returns of the S&P 500 index over that time frame by 6.5%.
- In 2006, another academic study found that from 1995 to 2006, the average hedge fund underperformed the S&P 500 index by 2.6% annually. (Also note this time frame included a big bear market. A purported advantage of hedge funds is that they perform better in down markets.)
- In a 2001 academic study, authors studied 13 hedge funds finding that 92% showed no additional risk-adjusted returns.
- A 2003 study looked at hedge funds from 1994 to 2001, finding that the average fund of hedge funds (e.g., mega hedge funds) underperformed an equally weighted portfolio of randomly selected hedge funds by 3% each year. Thus, you’d do better by picking a random hedge fund.
Overall, this evidence contradicts the claim that hedge funds offer higher-than-average risk-adjusted returns. Furthermore, there is no evidence of the ability of any hedge fund to overperform beyond what is expected by chance.
That’s two big strikes against an entity whose sole purpose is to offer greater-than-average returns! This is basically the same problem that plagues actively managed mutual funds. More risk and more cost for subpar results.
7 Big Problems With Hedge Funds
There are even more problems with hedge funds that we haven’t gotten to yet. And many apply to physicians in particular.
No liquidity
Hedge funds have long lock-up periods. And the ability to withdraw funds can even be suspended by the manager. As we’ve seen, there is no additional return rewarded for this risk. This can be an issue for doctors, especially if funds are ever needed for a practice buy-in or something similar.
No transparency
Hedge funds don’t have to disclose how they are investing your money. That’s a huge risk. Especially when one of the most important tenets of your financial plan is your asset allocation! In a hedge fund, you give that up.
Could you imagine performing surgery or a procedure without informed consent?
Bad distribution of returns
When you look at hedge funds, they have non-normal distortions of return. They are negatively skewed, meaning that most hedge funds lose, but losses are small (although big losses happen at a greater-than-usual frequency) and a few winners win big. This is the same distribution that lottery tickets exhibit.
They die
This sounds dramatic, but that’s exactly what they do. Take two studies, also referenced in Swedroe’s book, as evidence. A 2005 study by Burton Malkiel, one of my favorite economics writers, found that less than 25% of hedge funds in existence in 1996 were still functioning in 2004. Another study found that the median lifetime of a hedge fund is just 5.5 years. That’s not good when we should be investing for the long term with a goal of financial freedom.
They are risky
Hedge funds use leverage and invest in illiquid assets. This results in greater risk. However, in most cases, hedge funds and even studies of them use less risky benchmarks as their comparison. This is deceiving because on a risk-adjusted basis, hedge funds actually perform even worse!
We will talk more later about why doctors in particular don’t need to take more risk.
They are very tax inefficient
Hedge funds have massive turnover. This means more tax implications in addition to the higher fees.
Most doctors I know are trying to reduce their tax burden. Hedge funds won’t do that. And the subpar returns are no consolation for these higher taxes.
The house always wins
There is serious risk that we need to discuss called agency risk.
Most hedge fund managers are rewarded by incentive pay in the form of 20% of profits. Agency risk shows up in a hedge fund when, towards the end of the year, a manager fails to reach or exceed their goal returns. The manager is incentivized to take more risk to boost returns. If they succeed, they get a bonus. If they don’t, then they still receive the minimum pay.
They always win. You probably lose.
These are big problems, especially for doctors.
As physicians, we earn a high income. We are more fortunate than most in this regard. As a result of our income, our recipe for financial freedom is pretty simple:
- Save at least 20% of our gross income
- Invest that money wisely
And because of our large income, we can adjust our savings to create a bigger margin between what we earn and what we spend if we need to accelerate our path to financial freedom.
The one thing we really don’t need is to take on excess risk. Returns are a big part of what will grow our nest egg to retirement. But an even bigger part of the equation is the savings.
By taking on excess risk in our investments, we actually decrease our returns (see data above) and increase our risk of not becoming financially independent. As a result, burnout ensues, we suffer, our patients suffer, and the field of medicine suffers.
All That Glitters Is Not Gold
Hedge funds, like active investing in general, are built on the whimsical notion that it is possible to beat the overall stock market. Unfortunately, that is just not possible.
Someone may beat it today. But they are no more likely to do so in the future than luck would dictate. Avoid the static. Ignore the noise. Stick to sound investing principles.
Jordan Frey, MD, is a plastic surgeon at Erie County Medical Center in Buffalo, New York, and founder of The Prudent Plastic Surgeon.
Looking to improve your financial well-being? Check out Frey’s online course, Graduating to Success, a comprehensive and interactive 12-module course that helps doctors achieve personal, professional, and financial success during and after their transition from trainee to attending. Or read his best-selling book, “Money Matters in Medicine.”
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