2007: Crazy Happens, Part 1

This situation is crazy. It's as if a major-league baseball team decided to pay every player on its roster the same salary as Alex Rodriguez. (Wait a second. The Yankees might actually be trying to do this!) The fact that the team owner may be able to afford the enormous cost is beside the point; it would still be irrational. But this is exactly what most hedge fund investors are doing. They are overpaying, to the tune of billions upon billions of dollars, for investment services. And lots of hedge fund managers, fund-of-funds and prime brokers are laughing all the way to the bank.

Most wealthy and institutional investors who invest in hedge funds would be much better off in a mix of bond accounts and passive or actively managed long-only equity. If you're concerned about downside volatility (no rational person worries about upside volatility), you could inexpensively hedge your long assets with a variety of tools, including options strategies, shorting indices on a ratio or even some of the newly developed inverse ETF products. The all-in cost of all of these strategies would be much lower than just about any hedge fund product that is available.

In fact, many hedge fund investors would even be better off allocating their capital to actively managed mutual funds. This is a sacrilegious statement in the hedge fund community, which generally castigates long-only investment managers. But, to use one example, Bill Miller might be the best money manager alive right now. If you hire him to manage a portion of your money in his (LMVTX Quote)Legg Mason Value, you'll pay under 2% per year in expenses for the privilege -- and you'll keep all of your after-tax profits. That might be a smart move for the cost-conscious investor. But paying more than 2% per year and more than 20% of the profits to most hedge fund managers? Crazy.