Hedge funds are supposedly where the smart money is being invested. But most hedge fund managers underperform the market. These five hedge fund managers have done quite well.

In his fifth career—as an investment manager—Alfred Winslow Jones contributed $100,000 to create the first hedge fund for wealthy investors in 1949. It is speculated that the skills he picked up in his previous careers working on a steamship, and as a diplomat, sociologist, and journalist served him well as a hedge fund manager.

Today, the hedge fund concept is alive and well. Catering to “qualified” investors—those with $1 million or more to hand over—there are now some 2,700 such funds, according to the United States Hedge Fund List. And, as you might imagine, they are primarily headquartered in the well-heeled enclaves of New York, Chicago, San Francisco, Dallas, Greenwich, and Boston.

Hedge funds became very popular in the 1990s and grew rapidly, gathering assets of more than $1.93 trillion by the time the 2007-2009 recession hit. They suffered a setback during the hard times, as many of them began limiting investor withdrawals. However, all was forgiven, and hedge funds have since rebounded, and now hold an estimated $3.1 trillion.

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Like a mutual fund, hedge funds pool investor funds in order to make some pretty hefty investments—which, in many cases gives them enough leverage to buy large ownership positions in companies, to get a seat on the board, or at the very least, change company policies and strategies.

And speaking of leverage, many hedge funds are highly-leveraged, which they do to increase their returns, and that is a big risk for investors and can—and often does—lead to huge losses. The funds can also increase risk by investing in land, real estate, stocks, derivatives, and currencies, unlike mutual funds or ETFs, which are mostly limited to stocks and bonds. Additionally, hedge funds come with several other disadvantages:

Illiquidity: This arises from investing in illiquid securities that may have long lockup periods or a longer-than-usual notice for redemptions.

Limited access: As I mentioned above, if you don’t have deep pockets, you won’t be welcomed as a hedge fund investor.

High fees: Investing in a hedge fund is usually more expensive than investing in mutual funds or ETFs. These funds’ annual asset management fee can add up to 1-2%, and most include a performance fee of 20% of a hedge fund’s profit.

Taxes: Depending on the structure of the fund and where it is located, investors may find themselves paying income rather than capital gains taxes.

How Well Do Hedge Funds Really Do?

You see hedge fund managers like Bill Ackman, David Tepper, and Carl Icahn on CNBC all the time. The journalists spend lots of time trying to figure out what these wealthy managers are buying for their funds.

But when you look at their returns, you may want to ask yourself why anyone—other than their investors—care.

As you can see from the following graph, the average return of hedge funds over the past 18 years has greatly lagged a portfolio of 60% global stocks and 40% U.S. bonds.

And despite a pretty good market this year, according to evestment.com, in June, hedge funds averaged gains of +2.07%, for a year-to-date total return of -3.37%. Evestment says that only 40% of the industry has produced a positive return this year, with the average gain +9.12% while the average decline is -10.85%.

Meanwhile, the Dow Jones Industrial Average, the S&P 500 Index, and the Nasdaq have posted returns of 3.75%, 11.33%, and 31.15%, respectively, in 2020.

The Top 5 Hedge Fund Managers

Nevertheless, there are some hedge fund managers who have done very well. According to TipRanks.com, here are the Top 5 Hedge Fund Managers (out of 200), who have made the most money for their investors over the past three years: 

What are Hedge Fund Managers Buying Today?

And while most hedge fund managers lag the market, investors still want to know what the “big money” is buying. The answer: mostly Technology (31.23% of investments), Services (18.55%), Financials (15.77%), Healthcare (13.77%), and Consumer Goods (7.92%).

WalletHub.com recently surveyed 400 of the largest hedge funds to see what they were buying, and here are their Top 10:

10 Most Popular Hedge Fund Stocks

Source: WalletHub.com

There you have it—this is where the big money is going. As you can see, it’s mostly in tech, where values have climbed to the stratosphere this year. My advice—it’s always good to see where money is flowing, as that helps boost stock prices, but it’s always wise not to chase momentum too high.

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Nancy Zambell, Chief Analyst of the Financial Freedom Federation, has spent more than 30 years helping investors navigate the minefields of the financial industry. Nancy's book, Make Money Buying & Selling Stocks is an introduction for new investors and a reminder for experienced investors on how to profit in the stock market.

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Note: This post has been updated from an original version.