What happens when too much money is chasing too few deals? In the end, the deals stop being such great deals.

A hedge fund might then keep the cash, patiently waiting for the right opportunity. This too has negative consequences though. The low yielding cash hurts the internal rate of return (IRR) creating a drag on the fund, and in turn, the reputation of the managers. Since the fees (1% to 2% of assets) and profit sharing, as much as 20% of the return over some minimum are based on success, time is not on the side of the hedge fund.

There are so many hedge funds in the market place with more being created all the time that the law of averages will reduce most to mediocrity. Like many things in the investment world, be it mutual funds, exchange traded funds (ETFs), closed end funds or analysts opinions, they are all carried to excess.

I would venture to speculate that traditional low fee index funds like Vanguard's S&P 500 fund or Total Stock Market fund will beat 80% of the hedge funds over the course of time, just like they beat 80% of the stock pickers in any given year.

Continue reading Too many hedge funds, too much money

Too many hedge funds, too much money originally appeared on BloggingStocks on Thu, 03 May 2007 15:45:00 EST. Please see our terms for use of feeds.