Myths and Realities About Hedge Funds

05/30/2007 12:00 am EST

Focus:

Nicholas Vardy

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

Nicholas A. Vardy, editor of the Global Guru, says the mystique of hedge fund managers as rich, powerful, risk-taking geniuses doesn't stand up to the more modest reality.

Hedge funds are hot. Few financial innovations have caught investors' attention more than these mysterious entities that seem beyond the understanding of mere mortals. Hedge funds are seen as a combination of high rollers and academic whizzes, generating unspeakable wealth-and the universal bogeyman behind every unexplainable market hiccup. Yet under closer scrutiny, few of these myths hold water.

Myth #1: Hedge funds are high rollers-they win (and lose) big
The Reality: In recent years, returns at most hedge funds have plummeted from astronomical to average. In 2006, hedge funds lagged the Standard & Poor's 500-stock index. It turns out there is no free lunch-even in the hedge fund world. If you want returns, you need to take the risk. And hedge funds have turned from tigers into pussycats.

Myth #2: Hedge fund managers are all rich
The Reality: The popular image of hedge fund managers' lifestyles is a lot like that of movie stars. And the odds of achieving that lifestyle are about the same. With 9,000 hedge funds around, there are a handful of Brad Pitts and Angelina Jolies, with thousands of equally (or more) capable thespians inspired by their example. But like actors who moonlight as waiters, many hedge managers struggle to attract sufficient assets to even make a living.

Myth #3: All hedge fund managers are academic whizzes
The Reality: The most prominent hedge fund managers seem to be testosterone-driven, competitive types who feel more at home training for a marathon or jumping out of a plane than understanding the limits inherent in risk models based on Gaussian distribution curves. Conventional financial acumen is just not necessary. Want proof? Warren Buffett was rejected by Harvard Business School and George Soros could never pass his securities analysts' exams.

Myth #4: "The market dropped 2% today thanks to selling by hedge funds."
The Reality: The reporters at Bloomberg (and elsewhere) need an explanation for every market movement. These explanations are little more than fiction-diligently confirmed by an actual quote from a reliable source sitting in a large financial institution.

The bottom line is hedge funds have gone from financial swashbucklers of yore to boring "providers of liquidity" today. That may keep hedge fund carpetbaggers happy as long as fees stay high. But for the genuine future of the Warren Buffetts and George Soroses of the world, the attraction of homogenized, steady, low returns is waning rapidly. Ironically, the more successful hedge funds become, the more it will lead to an exodus of genuine talent. The smart money will soon follow them.

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