After CalPERS, the largest public pension fund in the U.S., announced this month that they're selling all 30 hedge funds in their portfolio - about $4 billion--investors might be asking "Should I sell my hedge fund?" The short answer: Yes.
For many years hedge funds were boutique investments that attracted wealthy and institutional investors by promising higher returns, lower risk, or both, through active trading strategies.
A few funds had outstanding performance, though it's not clear if it was due to skill or luck.
For some hedge funds, their extraordinary performance may have been due to illegal insider trading, as in the case of Matthew Martoma, who was recently sentenced to nine years in prison for insider trading at SAC Capital Advisors.
But hedge fund investors have had to deal with some serious issues:
• Hedge funds are expensive. The typical annual fee is 1.5% to 2.0% of the investment value plus 20% of the profits, significantly higher than the combined cost of paying a wealth manager and the cost of index funds.
• Hedge funds are often not liquid. Many times investors are required to keep their money in the investment for several years. With other funds, you might initially be able to withdraw money quarterly or annually, but if everyone wants their money at the same time, which is what happened in 2008-2009, then liquidity could evaporate, leaving your money locked up indefinitely.
• Lack of transparency. Unlike mutual funds and exchange traded funds (ETF's), hedge funds aren't required to disclose their holdings. It's difficult to know what they're really doing with investor money.
• Some hedge funds are very risky since they use financial leverage, high-frequency trading and other high-risk techniques. Long-Term Capital Management, a firm started by Nobel Prize winners and Wall Street luminaries, crashed and was bailed out by the Federal Reserve in 1998, and subsequently shut its doors.
Not all hedge funds take high risk. Some of the more conservative strategies try to smooth out market extremes. That may sound attractive to some investors, but today there are a plethora of mutual fund and ETF choices to invest in these alternative strategies, so you don't need a hedge fund for that reason alone.
Morningstar Inc. currently tracks over 1,800 mutual funds and ETF's that use these alternative strategies, known as liquid alternatives, or "liquid alts." It's not surprising that liquid alt funds are one of the fastest growing categories of mutual funds.
With lower costs, daily liquidity and transparent reporting requirements, mutual funds and ETF's are a superior alternative to hedge funds. Replacing a hedge fund with a liquid alt fund and a portfolio of low-cost index funds will likely produce similar returns at a much lower cost, and without all the hedge fund headaches.
CalPERS found that the cost and complexity of hedge funds outweighed the benefits. If the largest public pension fund in the U.S. has figured this out, it's likely that other large investors will eventually follow suit.