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Hedge Funds Can Advertise -- Here's Why You Shouldn't Listen

Thanks to the 2012 Jumpstart Our Business Startups Act, the decades-long ban on hedge fund advertising ended Monday. The question you need to consider is whether you should pay attention.

Hedge funds have almost been a secretive society in the investment world. Individual investors are largely prohibited from buying hedge funds, and despite the change in the rules about advertising, many will still be locked out of the market. The good news is that hedge funds might not be the best possible investment for most individuals.

Only accredited investors can invest in hedge funds. Securities and Exchange Commission (SEC) rules define accredited investors as those with an annual income over $200,000 ($300,000 for a married couple) or a net worth over $1 million, excluding a primary residence. Less than 7.5% of households in the U.S. meet this requirement.

Advertising might make more investors aware of hedge funds, and the 92.5% of households that are not accredited might wonder what they are missing in their portfolios. The short answer is that investors aren't missing much. But marketing is likely to generate interest in new products.

There could be an increase in the number of ETFs and mutual funds that offer a way to access hedge funds through indexes or strategies that replicate the funds' holdings. There are some hedge fund index tracking ETFs already available, and they have not generally provided returns that beat more traditional strategies. However, low returns have never prevented new investments from being offered.

The hedge fund industry is rather diverse. There are actually more than 9,000 hedge funds managing over $2.4 trillion for investors. The 10 largest funds account for more than 16% of the industry, and these funds are unlikely to be advertising. The best hedge funds are usually closed to outside investors.

Since the very best funds will not likely be accepting new investors or advertising, the ads we will be seeing deserve a detailed analysis before we invest. The first step in the analysis should focus on performance, which you may find to be surprisingly poor.

There are several hedge fund indexes available. The Credit Suisse Hedge Fund Index might be the most comprehensive and is shown below. Also shown is a total return index based on SPDR S&P 500 (NYSE: SPY) so we can compare hedge funds to a traditional stock market investment.

Hedge Fund Index vs. SPY

The hedge fund index has been less volatile than SPY over the past 20 years. In the 2008-2009 bear market, the hedge fund index lost less than 20% while SPY fell by more than 55%.

Because the top funds account for so much of the index, the returns and volatility shown are biased toward their performance. There were a number of funds that did not survive the bear market.

The other factor to consider when reviewing hedge funds is the high cost of the investments. Hedge funds operate on a "Two and Twenty" model. The manager gets 2% a year in management fees and 20% of the gains above a benchmark. The best fund managers get more than that, and some funds will take less than that.

If a fund charging 2% and 20% gains 15% in a year when the benchmark index is up 10%, fund investors would pay 3% of assets to the manager (2% in management fees and 20% of the excess return, or 20% of 5%, which is 1%).

Over time, the performance of the hedge fund index has been mixed, and in the past five years, the S&P 500 index has outperformed the hedge fund index by a wide margin.

Hedge Fund Index vs. S&P 500

Investors should probably ignore the ads they will see for hedge funds, and they should also consider avoiding long-term investments in ETFs or mutual funds that track hedge funds.

Instead, investors should consider maintaining a balanced portfolio using traditional investments. One approach to consider is a 60/40 portfolio with 60% allocated to stocks and 40% to bonds. The exact allocations could be modified depending on your personal circumstances with a 70/30 or 50/50 split being appropriate for many investors.

Bond investments should almost always be in ETFs or mutual funds. For the stock portion of the portfolio, consider maintaining some core investments in index funds and allocate some exposure to individual stocks and options. This could provide market-beating gains without the risks and expenses of hedge funds.