3 Hedge-Fund Myths Exposed

04/27/2011 4:49 pm EST

Focus: MARKETS

Nicholas Vardy

Editor, Bull Market Alert, The Alpha Investor Letter, and The Global Guru

The best way to profit from a hedge fund may be to start one. In the meantime, consider a proxy that mirrors hedge-fund strategies at a fraction of the cost, writes Nicholas Vardy in The Global Guru.

Hedge funds are Wall Street's ultimate financiers: both high rollers and academic whizzes, generating billions for themselves and their investors.

According to the Financial Times, the Top Ten hedge funds made $28 billion for clients in the second half of 2010. That's $2 billion more than the net profits of Goldman Sachs (GS), JPMorgan (JPM), Citigroup (C), Morgan Stanley (MS), Barclays (BCS), and HSBC (HBC) combined. George Soros alone has made $35 billion for his clients since he set up his Quantum Fund in 1973.

But as you'll see, the returns of most hedge funds aren't all that special. The wealth of top hedge-fund managers comes from a combination of savvy marketing and a generous fee structure, more than market-walloping performance.

And today, you can actually generate hedge fund-style returns, simply and easily...

Myth No. 1: Hedge Funds Are High Rollers—They Win (and Lose) Big
Hedge funds are the high rollers of the finance world. They take huge risks to generate huge returns.

The iconic hedge-fund trade was George Soros' $10 billion bet against the British pound sterling. That single trade netted Soros a $1 billion profit in 1991.

His rationale on betting big? “It takes courage to be a pig.”

But bets like this can also lead to catastrophic losses. Long-Term Capital Management's massive losses in 1998 brought the financial world to the brink when the firm’s highly leveraged bets went bad.

The Reality
In recent years, returns at most hedge funds have plummeted from astronomical to unimpressive.

In 2010, hedge funds lagged the S&P 500, returning 10.5% versus 15.06% for the S&P 500. In 2009, hedge funds underperformed by even more.

So what happened?

Early in his career, wealthy individuals backed George Soros to swing for the fences. But in recent years, staid and boring pension funds have become the gorilla in the hedge-fund industry.

Pension funds view hedge funds as a way to diversify beyond stocks and bonds. At the same time, they don't want the risk associated with chasing blowout returns.

As pension funds’ appetite for risk has fallen, so have the returns of most hedge funds.

The result? Hedge funds have transformed themselves from tigers into housecats.

NEXT: Myth No. 2: All Hedge Fund Managers Are Rich

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Myth No. 2: All Hedge Fund Managers Are Rich
The popular image of hedge-fund managers is hard-charging finance types who scream at flat screens during the weekday and helicopter to the Hamptons every weekend.

The winners in the hedge-fund game do make an extraordinary amount of money. In 2009, seven hedge fund managers took home at least $1.3 billion for the year. The average manager in the top 25 received more than $1 billion apiece.

Collectively, they took home $25.3 billion—equivalent to the gross domestic product of Panama.

The Reality
Most hedge managers are like aspiring actors trying to make it in Hollywood.

At the top of the Hollywood food chain, there are only a handful of Brad Pitts and Angelina Jolies, with thousands of equally capable actors struggling to make it.

Most of the 9,400 hedge-fund managers are like actors who moonlight as waiters and waitresses on Hollywood Boulevard. They struggle to make enough money to earn a living, let alone spend it on third homes and yachts.

As with becoming an actor, a bestselling author, or the founder of the next Facebook, making billions in hedge funds has at least as much to do with getting a lucky break as with talent.

Myth No. 3: All Hedge Fund Managers Are Academic Whizzes
Hedge funds attract the supermen of the financial world. They are rocket scientists with PhDs from MIT, equally at ease running marathons and playing Polo at the Queens Club.

The Reality
George Bernard Shaw noted, “All professions are conspiracies against the laity.”

The hedge-fund profession is no different.

The aura of sophistication behind hedge funds largely is due to the Greek alphabet soup of financial terms—your alpha, beta, gamma, theta, vega—and textbooks chockfull of mathematical equations designed to dazzle the uninitiated.

But as with the Wizard of Oz, once you lift the curtain, there's a lot less there than you think. And what is there works worse than advertised. For proof, you need not look further than the implosions of AIG (AIG), Fannie Mae, and Freddie Mac.

Nor are all hedge-fund types brainiacs. Warren Buffett was rejected by Harvard Business School. George Soros could never pass his securities-analyst exams. And—confirming Main Street's worst suspicions of Wall Street—Galleon's Raj Rajaratnam is now on trial, accused of cheating through insider trading.

Brainiacs don't tend to be cheaters.

How to Generate Hedge-Fund Returns
Today, you can replicate hedge-fund returns through several exchange traded funds (ETFs).

My current favorite is the Credit Suisse Long/Short Liquid Index ETN (CSLS), an ETF that tracks the Credit Suisse Tremont Long/Short Equity Hedge Fund Index. And the number of hedge-fund strategies you can replicate through ETFs is growing by the month.

CSLS is an ETF I use not to “shoot the lights out” with soaring returns, but more as a kind of “shock absorber” against market downturns.

The ability of ETFs to mimic the returns of hedge funds for index fund-style returns highlights the ultimate truth about hedge funds: The best way to make millions is not to invest in a hedge fund, but to set one up.

And that's no myth...

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