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Hedge Fund Hijinks To Continue After SEC Move

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If you can get past the hypophallic cover of this week's Bloomberg BusinessWeek, there's a story that the hedge fund industry wants you to avoid.

Hedge funds aren't worth the exorbitant fees they charge.

Just like actively managed mutual funds, hedgies can't consistently beat the market. And with the predominant 2-percent annual fee/20-percent profit haul, that consistently stacks the odds against them in an economy barely growing at 2 percent.

The piece, headlined "Hedge Funds are for Suckers," and expertly written by Sheelah Kolhatkar,  notes the decline of the once fast-charging industry, which manages some $2 trillion in assets. Once the darlings of Wall Street, they are lagging the market and losing their assets.

All you need to know about the piece is an illustrative bar graph. For eight of the last 10 years, a simple stock-market index fund would've beaten most hedge funds. This year, hedgie performance is even more dismal, as Ms. Kolhatkar reports:

"According to a report by Goldman Sachs released in May, hedge fund performance lagged the Standard & Poor’s 500-stock index by

approximately 10 percentage points this year, although most fund managers still charged enormous fees in exchange for access to their

brilliance. As of the end of June, hedge funds had gained just 1.4 percent for 2013 and have fallen behind the MSCI All Country World

Index for five of the past seven years, according to data compiled by Bloomberg."

If investors have been played for suckers for most of the past decade, how are hedgies still staying in business and still charging those outrageous fees?

One reason is investor inertia. People rarely like to stomach losses and move on. They stay in and hope that things will turn around. They are seduced by the greed-soaked sales pitch that their managers can find "special opportunities" that the other managers haven't discovered yet.

In other words, investors are still smoked by the pure hokum of money managers who claim that they alone can ferret out unique profits when an entire global market has somehow missed them.

Little of what Ms.  Kolhatkar reveals is particularly new. Money manager Simon Lack blasted away at hedgie hijinks in his book "The Hedge Fund Mirage" last year. When Lack did the math, he found out that you'd do better investing in boring U.S. Treasury Bills than investing in most hedge funds. In fact, you'd do twice as well investing in treasuries.

When I saw Lack debate hedge-fund advocate Ed Butkowsky late last year at a conference in Chicago,  Lack was the hands-down winner. I asked Butkowsky to elaborate on his defense of the industry, but he never replied.

Just when you thought there were several nails being added to the coffin of the hedge-fund myth, the U.S. Securities and Exchange Commission (SEC) yesterday greenlighted the ability of private funds to advertise their products to even more unsuspecting investors.

Rather than stand their ground and demand honest disclosure about managers' abilities to beat the market after fees, the sheepish SEC opened the door to yet another round of investor deception. Even though only "accredited" investors with at least $1 million in net worth (excluding a home) could purchase these products, no new meaningful safeguards were put in place.  Before this rule change, hedgies were barred from advertising to investors.

Investor-protection advocates and state securities regulators blasted the SEC move. Here's what the Washington Post reported:

"Under the new rule, the SEC will allow firms to advertise to whomever they want. But only accredited investors with a certain net worth or

income will be allowed to make a purchase. But the net-worth and income thresholds have not been adjusted for inflation since 1982, and

Congress has barred the SEC from making immediate adjustments. Investor advocates say the thresholds are far too low. Anyone with a net worth of more than $1 million (with or without a spouse) or an income exceeding $200,000 (or $300,000 with a spouse) would qualify as

accredited. A person’s primary residence is not part of the net-worth calculation because of a recent change in law. It will be up to the firms to take “reasonable steps” to verify that investors are accredited. The industry said lifting the advertising ban makes sense. In the age of

the Internet and social media, it is of little use to limit who should know about private offerings; far more important, the industry said, is

to restrict who can buy them."

While I think hedge funds didn't deserve to get a new lease on life with the SEC's blunder, I'm not against them advertising. But I'd like to see some caveats:

* Show in dollars and cents, how much investors stand to lose from fees and other charges over a one-, five- and 10-year period (just like open-ended mutual funds).

* Report all returns net of fees.

* Compare all returns to appropriate indexes, especially how they performed in 2008 (if they were in business then).

* Show the impact of market-timing decisions.

* Provide the "alpha" and "beta," that is, how much value they added relative to a risk-free index and how much they are linked to the market as a whole.

* All of this information should be on the first page of any marketing literature. In bold letters, it would clearly state how much you could lose. It would be akin to a cigarette warning, only stating "this fund is hazardous to your wealth."

Will this kind of disclosure come about any time soon? I doubt it. But investors need blunt and crystal-clear cautions before they can invest. And it won't matter if they're "accredited" or not. Plain language works wonders when you state the hidden potential for poor performance.