Much attention has been paid lately to Goldman Sachs’ decision to “help” average folks (a.k.a. the 99% crowd) access the kind of high-stakes hedge funds once available only to the superrich (a.k.a. the 1%). And while all sorts of pundits and investor advocates have noted the folly of this and similar ideas, there’s a case to be made that the opposite is true — that average investors might do well by throwing some money Goldman’s way. In fact, there are two cases to be made. Allow me to explain.
But first, let us stipulate that investing in this and most other hedge funds as they operate today is a really dumb idea — not just for regular Joes but for pretty much everybody else too. Why? Because hedge funds, which were once a way for the very rich to cushion their fortunes against falling assets prices (thus the word hedge), have essentially become a way for their owner-operators to make tons of money from management fees and profit sharing while their investors get soaked trying to outperform the investing masses. (This development would get the hashtags #RichWorldProblem and #WhoReallyCares were it not for the fact that a lot of pension funds and college endowments are hedge-fund clients. But that’s for another column.)
Three things, in particular, contribute to this reality:
1. Ridiculous Fees
Most hedge-fund managers are paid by what is shorthanded as the “2-and-20” model. That is, each year they earn a 2% asset-management fee (vs. about 1.45% for the average mutual fund and 0.25% for index funds) plus 20% of any profits they produce. Given that, from 1998 through 2012, hedge-fund managers earned $379 billion in fees while their investors earned only $70 billion in investing gains, a better shorthand for this fee structure would be the “there’s-a-sucker-born-every-minute” model.
2. Lousy Performance
Hedge funds of late — and for quite a while — haven’t performed especially well. In fact, they’ve underperformed the overall market. As Barry Ritholtz wrote for the Washington Post:
The latest performance data (via the HFRX Global Hedge Fund Index) reveal that hedge funds haven’t fared well at all: they returned a mere 3.5% in 2012, while the S&P 500-stock index gained 16%. Over the past five years, and the hedge fund index lost 13.6%, while the indices added 8.6%. That’s as of the end of 2012; it has only gotten worse in 2013. Most hedge funds have fallen even further behind their benchmarks this year, gaining 5.4% vs. the market’s rally of 15.4%. As a source of comparison, the average mutual fund is up 14.8%.
3. Stupid Risk
Fueled by a lust for absolute profits and armed with the ability to invest in pretty much anything the managers choose — with borrowed money, to boot — hedge funds have morphed from a way to protect assets to a catalyst for losing them. Long Term Capital may be the most famous hedge fund to go belly up, but hundreds have since followed suit.
All of which suggests that the Goldman Sachs Multi-Manager Alternatives Fund — a mutual fund that invests in various hedge funds and is open to anyone who can plunk down $1,000 — is to be avoided at all costs. And I basically agree with that, with a minor exception based on two important points drawn from behavioral economics, which probes the psychology of money-related decisions.
1. It’s Better to Get a Little Sick Than a Lot Dead
We know from countless studies and, at this point, decades of research that it’s virtually impossible for investors (professional or otherwise) to consistently and reliably choose winning stocks or mutual funds. (In fact, the most active and confident investors tend to sell winners and hold losers.) This is not up for debate, no matter what your broker tells you, and for this reason most investors — from individuals to institutions — are better off putting their money in passive index funds.
But we also know that most if not many investors have a tough time disciplining themselves from trying to beat the market. For this reason, many behavioral-econ experts recommend that investors cordon off a small portion of their portfolio for actively managed stock, bond, or other-asset picking. For one thing, there’s always a chance they might get lucky, even over the long term. But more importantly, if they are unlucky they will have shielded the majority of their nest eggs from the damage while still enjoying the buzz of being in the game. This is one reason for putting a small portion of your savings into Goldman’s new “fund of funds”: you’ll enjoy the thrill of the hunt (and have something to talk about at cocktail parties) without any chance of the gun blowing up in your face. At worst, you’ll get some minor powder burns.
2. You Can’t be a Contrarian Unless There Are People Who Disagree With You
The second reason to invest a little dough in the Goldman Sachs Multi-Manager Alternatives Fund is more subtle (and insidious) but nonetheless valid. Index-fund investing works in large part because you’re riding the bumpy but long-term upward trend of an asset class or economy while spending less in fees to do so than the average investor. That is to say, despite the humongous growth in passive investing, far more money is invested in actively managed funds, whose average investors pay far too much in management fees than they should, which drags down their overall investment performance, which helps to explain why index funds outperform actively managed funds.
This leads to the counterintuitive reality that while the best advice for almost everyone is to become a passive investor, almost every passive investor benefits from the fact that most people ignore this advice. And so, from a purely selfish perspective, it’s worth keeping funds like Goldman Sachs Multi-Manager Alternatives Fund in business for the same reason that high-occupancy-vehicle-lane users don’t mind single-occupancy cars: the more of them there are the faster and smoother your journey.