Are Index Funds Right For You?

The dream of many real estate investors is to build enough net worth to diversify into hedge funds. However, hedge funds frequently underperform index funds. These “unicorn” funds can invest in just about anything, including complex derivatives. Great flexibility and sophistication should ensure excellent results, but this is not always the case. 

6 Reasons For Choosing Index Funds

1. Hedge funds have very high fees. The only people that consistently make money from a hedge fund are the fund managers. The standard fee structure is 2% plus 20% of the profits. If the fund loses money, the managers are still paid. They also take a big chunk of any profits. 

• If you’ve ever wondered why hedge fund managers are often billionaires, now you know.
• These fees are tough to overcome. A 2% fee means you’re already 2% behind. Losing 20% of your profits creates an additional burden.
• Keep in mind that many index funds have fees under 0.2%, and they keep their hands off your profits.

2. Hedge funds have become too big. While index funds are enormous, this isn’t an issue. Many hedge funds have become too big to take full advantage of lucrative financial opportunities. When a great opportunity presents itself, the hedge fund can’t put enough money into that opportunity to obtain the best return. 

• Hedge funds must invest a significant portion of the fund in lower-quality investments. The size of a fund can be very challenging. Warren Buffett has often said he could earn 100% per year on a million dollars. Investing several billion dollars is very limiting.

3. The market is very efficient. This means that all the information available to investors has already been incorporated into the price of stocks. In theory, it isn’t possible to beat the market. 

• The market isn’t 100% efficient since investors regularly outperform the market. However, beating the market consistently is very challenging. Plus, to make up for that extra 2% fee, hedge funds must beat the market by more than 2%. That doesn’t even take into account the 20% profit scrape.
• Hedge funds must beat the market by a considerable amount to provide a competitive return to an investor.

4.   When hedge funds lose money, they can lose a lot. Hedge funds take on a high level of risk. Hedge fund managers love risk. They’re already guaranteed 2%. Any profits significantly increase their income. A high level of risk is also necessary to overcome the fee structure and provide high returns to investors.

• The ratio of risk to returns is relatively high.
• Hedge funds have a lot of exposure with margin accounts and short selling.

5. Low liquidity makes it difficult for the investor to get out quickly. If the future isn’t looking bright, getting your investment out of the fund can take time. You might watch your investment shrink daily before you’re able to cash out.

6. Index funds have too many advantages. Index funds can provide comparable market returns with little risk found in hedge funds. Hedge funds can’t consistently match the ability to guarantee market-matching returns with low fees.

Hedge funds look a lot like your real estate investments. Leveraged, low liquidity, higher risk, and potentially higher returns. When diversifying, look for asset classes, like index funds, that diversify the returns and the asset characteristics.