Minneapolis hedge fund exposes the dark side of hedge funds

Maybe becoming wealthy enough to have your money in a hedge fund is actually one of the drawbacks of getting rich.

Getting access to top hedge managers certainly did not work well for regular folks who had the chance to invest alongside the 1 percent by buying shares in the soon-to-be-closed Whitebox Tactical Opportunities Fund, managed by Whitebox Advisors LLC.

Investors lost money in the fund in 2014 while the S&P 500 returned double digits, and last year would also have been painful.

It would've taken a little out-of-the-box thinking to see investing in this fund as a good idea in the first place because five minutes with the prospectus is all it took to see this was no ordinary mutual fund. Like other hedge funds, this one had the freedom to pursue all manner of aggressive investment ideas.

In fact, given the wide array and complexity of the choices for what the managers could do with their investors' money, maybe the investment strategies section could have been summarized in three words: "Just trust us."

Buying a bucket of Gopher 5 lottery tickets was out of bounds, but not much else was.

The fund could buy the common stock of U.S. or non-U.S. companies, of big companies or little companies. Or it could buy the preferred stock.

The fund could buy bonds issued by governments or corporations or bonds backed by mortgages. It could buy investment-grade bonds or unlimited amounts of junk bonds.

It could sell stock short, hoping to profit on a price decline. Even more unusual for a mutual fund, it could buy or sell options or even trade in more exotic financial derivatives like total return swaps.

Doing all of these things more at less at once — buying, selling, shorting, trading, swapping — is what a lot of hedge fund managers do with their clients' money.

But investors in this fund, like investors in others like it, found out it wasn't that much fun to be a hedge fund investor the last couple of years.

Even in the lackluster year for stocks that was 2015, which maybe should have been a good year for hedge funds to outperform the broader market, this fund declined more than 20 percent. Anyone who lacked the ambition and vision to put money into this fund and instead stuck it in the Vanguard 500 Index fund would've actually generated a small return.

The Tactical Opportunities Fund was by far the biggest of three funds now being liquidated by Minneapolis-based Whitebox Advisors, a hedge fund manager that has a fine reputation for shrewd investing. Some of the investments in the Tactical Opportunities Fund seem easy to defend, like its big bearish call on some much-loved — and thus maybe overvalued — U.S. growth stocks. But once again it was the wrong season for this approach.

Whitebox elected to close the funds as the pace of redemptions created pressure to unwind investments, putting remaining shareholders at risk. By one count more than two-dozen other so-called "liquid alternative" funds like the Whitebox funds were shut down in 2015.

The idea behind these funds was to combine the structure of a regular mutual fund, where investors could get their money out of the fund any day, with more sophisticated investment strategies that could protect investors from steep losses in years with big market declines. That seems like a fine idea, but what ruined the appeal of these funds is the continuing poor performance of the whole hedge fund segment.

Last year was another bad year for them, according to estimated performance numbers just reported by the firm Hedge Fund Research Inc. Except for 2011, hedge funds returns have not beaten the broader stock market's returns in any year since the financial crisis of 2008.

Berkshire Hathaway CEO Warren Buffett is among the investors who look at these results and scratch their heads at the enduring popularity of hedge funds. Buffett is well on his way to handily winning a $1 million bet (for charity) that a low-cost index fund would beat the returns of hedge funds over 10 years.

His gripe with the hedge fund industry isn't the mediocre returns so much as it is the expensive fees. In a typical hedge fund, the manager gets 2 percent of the assets as a management fee, plus a 20 percent split of the profits.

The mutual funds managed by hedge fund firms had the far lower fees that are typical of mutual funds, but the fat fees of the private funds hedge fund firms manage have proved to be very durable.

In a good year, maybe with a savvy call on the market or some good luck, the hedge fund manager takes home one out of every five dollars of profits. In a bad year, with clients taking every dollar of the losses, the hedge fund manager still gets the 2 percent management fee.

It's a version of heads I win, tails you lose.

The industry's fee structure is one reason to doubt the reported investment performance, as funds that have a bad year apparently are often quietly shut, their performance then falling out of the reported industry results.

It's a little like the coach of a hockey team concluding at the end of the second period that the game probably can't be won, so he quits the game and right away tries to start playing another game, now once again with a chance to win.

And, oh my, are there ever rewards for winning. The most recent Rich List — yes, that's what it's called — published by Institutional Investor's Alpha news site reported that the best paid 25 hedge fund managers collectively got about $11.6 billion in 2014 and more than $21 billion in 2013.

The ranks of the super-rich have been swelling with people who made their money primarily by running hedge funds. There were 32 in the most recent ranking of the 400 richest Americans published by Forbes magazine.

It doesn't appear that anyone made this list by actually investing in hedge funds.

lee.schafer@startribune.com

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