Why You Shouldn’t Be Swayed By Hedge Fund Advertisements

“Promise, large promise, is the soul of an advertisements.”
–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