Why investing in exclusive alternatives can be an expensive waste of time

If financial markets were a nightclub, the VIP room upstairs would be where exotic investments such as hedge funds, art and fine wine, changed hands. To join them, you would need money, connections or both.

High-quality collectibles are expensive, and hedge funds typically have high-minimum investments because managers require them. So do regulatory agencies, like the Securities and Exchange Commission, based partly on the assumption that the wealthy are able to withstand a large loss and hire professional advisers to help invest in something so exotic.

But investors in exclusive alternative asset classes may reach the same conclusion as many who have paid to cross the velvet rope into the VIP room: Unless you get lucky, the experience can be an expensive waste of time.

Apart from the occasional spectacular individual performer, hedge funds have been conspicuously weak. The average hedge fund in Morningstar’s database rose 5.9% per year over the last five years through June; during the same period, the Vanguard Total Stock Market exchange-traded fund (ETF), which represents what an ordinary investor in stocks could have earned with little skill or effort, had an annualized total return of 17.6%. And that’s without paying the typical 2% annually and 20% of any outperformance.

STOCK PERFORMANCE

The stock market has been exceptionally strong since 2009, so it may be unfair to expect hedge funds generally to beat the market. When the comparison is between the Vanguard US Total Stock Market ETF (VTI) and hedge funds whose strategy is to hold long positions in stocks, the result is less lopsided but still unflattering; those hedge funds were up an annualized 14.6%, according to Morningstar, three percentage points per year less than the ETF.

The results are all the more uninspiring when you realize that these vehicles typically use borrowed money to try to enhance returns. That means incurring greater risk to achieve whatever gains are made, in the same way that a gambler who raises the size of his bets has put more on the line, whatever his net gain or loss.

(More: Hedge funds could suffer worst year since 2011)

Why have these vehicles done so-so (or worse), despite their cachet and the high minimum investment required? They’re expensive, for one thing. Borrowing money to add exposure itself costs money, even in an environment of low interest rates.

Management and other fees are generally higher, too, verging on outrageous. The average hedge fund management fee was an annualized 1.54% in the first quarter, according to Hedge Fund Research. That compares to a thinner 0.05% for the Vanguard Total Stock Market ETF.

INCENTIVE FEES

Far more onerous than the management fee is the incentive fee, a mainstay of the hedge fund industry. The incentive fee is a share of any gains generated, usually beyond a ‘high-water mark,’ or a peak net asset value attained before any intervening decline. The average annualized incentive fee during the first quarter was 17.73%, Hedge Fund Research reported. Note, however, that they do not pay you when they underperform. This does not make for a very fair arrangement, if you think about it.

The common fee structure at hedge funds has long been referred to as ‘2 and 20.’ That ‘1.54 and 17.73’ might be more accurate is little consolation, considering the results that managers have turned in. A reason for that, apart from the high fees, is simply that many of them, probably most, are not very good.

A recent report by Barclays Bank suggests that macro hedge funds, the sort that can invest pretty much in any market, have a habit of zigging when they should zag. Their average allocation to the stock market tends to be heaviest just ahead of declines and lightest after a decline has run its course.

WINE AND ART

Hedge funds may provide minimal advantage to a portfolio, but how about the finer things in life, like art and wine? The art market has been soaring, as indicated by this sub-headline on a report by The European Fine Art Fair, a respected authority on the subject: “Global art sales in 2014 break all known records.”

Sales and prices have been on the rise since the financial crisis dissipated, but the gains have been far from uniform. Buying has been concentrated in Postwar and Contemporary, the segment that includes artists like Rothko, de Kooning, Bacon and Koons, and Modern, especially at the top end of the top end.

As with hedge funds, there are indexes that seek to quantify the average return in art. But with so few transactions compared to mainstream markets, and results skewed dramatically by sales like the one in May of Picasso’s “Women of Algiers, Version O” for $179 million, the most expensive artwork ever sold at auction, averages become meaningless.

What is meaningful, on the other hand, is the high cost of buying, selling, and owning art. Commissions to dealers and auction houses can run well over 10% coming and going, and there can be additional expenses for restoration, shipping, cleaning, and insurance.

(Related read: Despite strong performance, advisers keep cork in wine investments)

Investing in wine can be pricey, too, with commissions that can be at least as high as for art, with added costs for storage and insurance. There is similar difficulty in computing a price for the average bottle of wine as for the average work of art, and when it’s tried the results are unimpressive. For example, the Liv-ex Fine Wine 100 Index peaked in mid-2011 and has fallen by about one-third since.

There is one excellent reason to own art and wine: the impact they have on your senses. As for the impact they have on your net worth, that’s a harder case to make.

In the end, one of the most celebrated aspects of exotic investments, from hedge funds to art to wine—their exclusivity—may be their greatest drawback. Whatever patrician appeal these assets hold, dealing in them involves a deficit of transparency and liquidity—even in wine, despite what connoisseurs and chemists will tell you—that often leads to high costs and low returns.

Understanding the cost of an asset and having a large pool of investors to buy from and sell to are essential features of a well-functioning market. The VIP room sounds like a desirable place to be, but if there isn’t much company and the cost of admission is high, you’re better off downstairs.

Dan Egan is the director of behavioral finance and investing at Betterment.