Why You Shouldn’t Be Swayed By Hedge Fund Advertisements

Yacht (Lady Mona K) in Skopelos

Expect lots of pictures of these in hedge fund advertisements.

“Promise, large promise, is the soul of an advertisement.”
–Samuel Johnson

I managed to spend nearly the entire first decade of my adult life almost completely unexposed to television advertising. Televisions weren’t common at West Point, and when I was stationed in Germany, we lived off the Army post and my housemate didn’t speak German, so we didn’t watch TV. When I did watch TV, it was in the mess hall, and it was the Armed Forces Radio and Television Service. Their advertisements were clearly created by government bureaucrats; if I were to ever watch (and understand) North Korean television, I imagine that the advertisements would be similar. They were terrible and unpersuasive; we would have been more entertained by watching a test pattern on the television than the AFRTS advertisements.

However, once I got back to the United States, I tried my best to make up for years of perceived loss of watching television by cramming as much TV watching into my spare time as I could. One advertisement in particular swayed me. It was for a Russ Whitney free real estate investing seminar. Since I was out of the Army and waiting to go to graduate school, I didn’t have much to do with my spare time, and I was impressed. “NO MONEY DOWN!” the ad informed me, and made lots of implied promises about how rich I could become by snapping up scores of houses, chanting a magic incantation, and flipping them.

Monkey Brain was howling with excitement. Easy riches! Yachts! No money needed! Sign him up!

Thus began a stuttering start to my real estate investing experience (you can read more about the real estate land mines I stepped on in my article on Bigger Pockets). I’d never considered investing in real estate until Russ Whitney’s ad came along. So, in a backhanded way, I guess I can thank him for the inspiration, if nothing else.

The power of advertising is unmistakable. While advertising is good to create awareness to brands that you might not otherwise be aware of, advertisers are excellent psychological masters. They’re not aiming those pictures of beautiful women driving cars and ripped ab guys doing whatever it is that they do (I don’t notice the ripped ab guys, to be honest) at you. They’re aiming all of those ads at Monkey Brain. You’re just along for the ride.

For 80 years, the Securities and Exchange Commission banned hedge funds from advertising their offerings to the general public. In a way, hedge funds were like Fight Club’s first two rules:

  • The first rule of Fight Club is: You do not talk about Fight Club.
  • The second rule of Fight Club is: You do not talk about Fight Club.

To participate in a hedge fund, you had to find a hedge fund. They could not find you through advertising.

In a recent reversal by the Securities and Exchange Commission, hedge funds are now allowed to advertise their offerings to raise capital. To understand what that means, it helps to explain what a hedge fund is.

A hedge fund is an unregulated investment fund that invests in a wide variety of investments which the average person doesn’t have access to. They will invest, usually, in long-short strategies (meaning buying some stocks and shorting others), derivatives (options – calls and puts), private placements (think: Facebook investors before it went public), and will borrow money for those investments. Because they’re investing in many more types of investments than your average person does, the SEC limits who can invest in them. For individuals, you have to meet one of two thresholds to become an accredited investor:

  1. Net worth excluding the value of your primary residence of $1 million or more, or
  2. Earn either $200,000 in income for the past two years or, if married, $300,000 per year in income for the past two years.

In 2008, there were between 5 and 7.2 million Americans who were classified as accredited investors. Given that the market hasn’t really moved much in aggregate since then, that’s probably still a reasonable guess as to the population of people who are eligible to invest in hedge funds.

Hedge funds typically charge a 2% management fee and 20% of profits earned. That can be an even steeper fee than front loaded mutual funds.

Are they earning their fees?

Between 2002 and 2012, hedge funds didn’t even beat inflation, underperforming the S&P 500 in 9 out of the 10 years. Historically, hedge funds were supposed to perform better in down years (hence, the term hedge), but recent performance has shown that shortcoming. That’s BEFORE you tack on fees. After fees, in the previous decade, hedge funds had a 17% return. The annualized S&P 500 returns, including dividends, during the same period were 54.3%.

Investing in a hedge fund is, simply put, a way to keep up with the Joneses through your investments. The people who invested in hedge funds in the past 10 years did so not to make market returns, but, rather, to be able to talk about being invested in hedge funds at cocktail parties and dinner conversations.

Now, though, hedge fund placements – where hedge funds raise the money to invest in – will be all over CNBC, Bloomberg, and websites where rich people flock.

If you qualify as an accredited investor, here’s what you can expect to see:

  • Appeals to exclusivity. They realize that there aren’t many people who qualify to invest in hedge funds in the first place. So, the hedge funds will try to create what is known as an in group bias with you as part of the cool kids club and those uninformed bozos on the outside looking in, wishing they were you. Expect lots of pictures of yachts and country clubs to appeal to the exclusivity of being a part of the group.
  • Displays of wizardry. The advertisements will discuss sophisticated quantitative models and talk of brilliant minds hired from the best of Wall Street designed to give you an “inside edge” in your investing prowess.
  • IMPLICATIONS of getting richer. Since nobody can come out and say that they can guarantee outperformance without getting in deep sheep dip with the SEC, these advertisements will skirt the water’s edge by implying that by using the wizardry and sophisticated black box modeling and secret incantations to Pluto, you’ll get unbelievable returns on your investment in the hedge fund.

The reality is that, based on the performance of the past 10 years, the only people getting rich in hedge funds are the ones who are running them and charging the outlandish fees.

If you’re not an accredited investor, it’s great to see those ads and use them as inspiration and aspiration to become an accredited investor. However, if you are one (or when you become one), don’t fall for the advertising. The numbers don’t lie. While they may turn around and outperform the general market, history is not on their side. Neither is it on the side of actively managed mutual funds, for that matter.

Don’t be swayed by the hype and the advertising. Instead, get rich (somewhat) quick by sticking to a prudent, reasonable, and wise approach. If you want to swing for the fences, there are other ways to do it.

Hedge funds: mystique or substance? Tell us what you think in the comments below!

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About Jason Hull

Jason Hull is a Fort Worth financial advisor. Before becoming a Fort Worth financial planner, Jason co-founded, built, and sold a software development company. He is a CFP candidate, has a MBA from the University of Virginia, and a BS from the United States Military Academy at West Point. He is the owner of Fort Worth financial advisor Hull Financial Planning.

Comments

  1. Great post Jason, as usual! I never really thought about the Hedge Funds and the SEC ruling. Interesting times ahead, eh?

    And thanks for linking to your BiggerPockets article! We’ll have to get you back to write another awesome post for us soon :)

    • I’d hate to be the poor soul in the Enormous Hedge Fund, LLC call center fielding call after call from ignorant, unaccredited investors: “I can get rich quick with these, right?”

      I’m going to be on another guest posting binge in conjunction with FINCON, so I’ll definitely hit you guys up. I already have the article 95% written, just waiting for the final numbers.

  2. Great post, there is so much wrong with this new rule. There are many accredited investors who have no business in a hedge fund but I fear many will be attracted for the reasons you mentioned. This is a bad deal for the public.

    • Nail, meet head. I hate to be pejorative, but I’ve seen some not-so-bright millionaires in my time, as I’m sure you have. I suspect they will be quickly and efficiently separated from their money. Despite the poor performance numbers, hedge funds still have a sexy allure that will draw in the unsuspecting like moths to the flame. I’m all for libertarian approaches and deregulation, but this is going to expose people to a lot of shiny objects without the understanding of the knives beneath them.

      Your U.S. News & World Report article on the same subject is also a good read.

  3. Hedge funds are generally a waste of time in the long run. Investing in market index funds is best!

  4. Nice post! Brings back memories…my family lived overseas for 10 years, where no television was available. When we got back to the U.S., it was like we had to make up for ALL THE YEARS OF HOWDY-DOODY SHOWS AND LUCILLE BALL SHOWS we’d missed! The machine was on from the time we rolled out of the sack to the time the last adult in the house crawled back into bed. :-D

    Nostalgia aside, this is one of the best definitions of hedge funds and explanations of why you should be careful that I’ve seen.

  5. I always keep my Monkey Brain locked in a closet and do my best to tune out the advertisement noise. You are right that the hedge funds will try to represent themselves as exclusive, wizards of the market, and the best path to riches. As far as I am concerned, the real wizards of the market are John Bogle, William Sharpe, William Bernstein, and their ilk. They are the people who teach the advantages of owning low-cost passive index funds.

    • I have the same approach that you do, Bryce! By the way, if you can sell locks for that Monkey Brain closet, let me know where I can get one! :-)

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