Merriam-Webster defines ‘hedge’ as “something that provides protection or defense.” For many investors, hedge funds conjure the same impression: If I buy a hedge fund in my portfolio, I will protect my portfolio from bad markets. Unfortunately, that statement simply is not true.

The hedge fund industry fails to adequately describe risk

The promise of hedge funds is to achieve better returns for investors, with less risk, than conventional funds that only purchase stocks. Hedge funds regularly use descriptions like “low volatility” or “low correlation with the market” to sell that promise to investors.

The reality is very different. For example, Sprott recently closed its Absolute Return Income Fund (Read about it in the Globe and Mail). Despite being described as “low volatility”, it lost 17.8% in one day, as the Swiss National Bank decided to remove its currency peg to the Euro. This led to the closure of the fund, and a permanent loss of investors’ capital. In a conventional stock fund, when the markets drop, patient investors eventually recover their money as markets recover. Investors in the Sprott Absolute Return Income Fund did not have that option.

Investors can’t properly measure hedge fund manager success

The author mentions that the impact to clients was limited since most of the fund’s capital was Sprott’s own money, not outside investors’. One might conclude that this is a good thing, a sign that Sprott endorsed their own product.

The other, and more realistic, interpretation is that the hedge fund industry is notorious for incubating funds. This practice involves starting a number of funds with house money and seeing which ones outperform. Those that don’t are closed down and never seen by the public or outside investors. Those funds that do succeed early are then marketed to the public aggressively. This gives the impression that the manager is always successful. The reality is that the manager is simply being selective, after the fact, about which funds it unveils to the public.

As a general rule in investing, what we don’t know, and can’t predict, determines our investment experience. The only way to truly mitigate that risk is to buy broad market funds that hold hundreds, if not thousands, of stocks. To do anything else only puts more money into managers’ pockets and reduces your odds of investment success.