No Reason to Worry About Decreasing Alternative Investment Returns

BusinessWeek's Steve Rosenbush is worried. "Finance experts," he says, are concerned "that hedge funds, as they grow and mature, are becoming too institutional, too bureaucratic, and too risk-averse. The fear is that the returns at many hedge funds are going to go from astronomical to average."

It's not just hedge funds, either. Private equity, too, is likely to see its returns go down, he says: "As the firms have raised billions of dollars, they have had to turn to large-cap deals where it's harder to find a bargain-basement deal."

Are you feeling sorry for the high net worth individuals who have to make do with 20% rather than 25% returns? You shouldn't be. What Rosenbush astonishingly fails to mention is that any remotely sophisticated investor can lever up hedge-fund or private-equity investments as much as they like, whenever they like. If they want more risk, it's very, very easy to get it.

The point is that it's not only hedge funds who can take on large amounts of leverage -- it's investors in hedge funds, too. If you think that a given fund is too risk-averse, you just invest in that fund using borrowed money, and -- presto -- your risks and returns have gone up. It makes perfect sense for hedge funds to be a little bit more risk averse, because that way they can attract the broadest range of potential investors. If investors want more risk, they can always add their own. The hedge funds are essentially leaving a bottle of hot sauce on the table, rather than making all their meals equally spicy for everyone.