Why advisers should — or should not — invest in hedge funds

To hedge fund or not to hedge fund? That was the question in Chicago Tuesday morning at the InvestmentNews Alternative Investments Conference. Facing off were two noted investors. Arguing the case against hedge funds was Simon Lack, principal and founder of SL Advisors LLC. Arguing for hedge funds and alternative investments was Ed Butowsky, managing partner of Chapwood Capital Investment Management LLC. Size affects hedge fund returns negatively, Mr. Lack said. “Better returns are associated with a smaller industry,” he said. The internal rate of return for hedge funds since 1998 has been half as good as the return of Treasury bills, he said. “In the 1990s, hedge funds did really well, but as investors have come into hedge funds, returns have come down,” Mr. Lack said. “Smaller is better for hedge funds,” he said, noting that the hedge fund industry controls $2 trillion in client assets. “Today, the hedge fund industry is overcapitalized. There are some good hedge funds, but the aggregate return has been poor. This has been a fairly major-flawed analysis by the institutional investing industry.” Standard hedge fund fees, with the manager charging 2% of assets and also gaining 20% of the return, continue to be an issue. “Everyone knows that is egregious,” said Mr. Lack, who recently wrote a book on the subject. “Today's hedge fund investors may think 7% [annual] return is a reasonable expectation, but that means every year would be a record year for the industry,” he said, adding that clients should have a very small allocation — 1% to 2% — to hedge funds in their portfolios. Mr. Butowsky countered Mr. Lack's argument, saying clients should have an allocation of 25% of their portfolio in hedge funds. “I'd have a lot more than that,” he said. He said that Mr. Lack's “information doesn't support reality. We're talking about performance but really need to ask, what is the purpose or benefits of having hedge funds in the portfolio?” “The reason we include hedge funds in the portfolio is to reduce the risk in clients' portfolios,” he said. “There are 14,000 hedge funds in the U.S, but only 250 are institutional-quality hedge funds. Our goal is to make portfolios efficient and get rid of waste.” Mr. Butowsky said that his hedge fund portfolio performed “miserably” in 2011, but he was not going dump the investments. “We have to be talking about the benefits of including this in the portfolio, not as a stand-alone,” he said. “As advisers, our goal is to help manage risk, and we have to add alternatives to the portfolio, because you can't have everything going up or down at the same time.”