There is nothing more mesmerizing than eye-popping percentage returns. While investors equate high returns to transactional intelligence, studies routinely show that randomness and luck are the far more likely explanations. Investors often don’t fully appreciate that all percentage returns are not created equal.

These occasional high returns earned by aggressive investments give them a marketing edge when investors troll for high returns, but they often find disappointment in their wake. I have written many times about the math of erratic returns and how consistency is often more valuable than higher average returns, but even that analysis falls short of fully exploring how bad the math is in practice; especially in hedge funds. For example, how is it possible for an 8% return to outrun a 22% return?  

Rate of Return Study

Segment recently concluded a study of returns in which we integrated combinations of the following factors: Short-term realized gains, tax-free Step-Up in Basis rule, a 2% hedge fund management fee, and a 20% fee on new trading highs. In each scenario we added a new detrimental barrier and solved for the return required to counteract the cost. However, the framework in each scenario remained the same: Turn $100,000 into $1million after-tax in 30 years. 

Percentage Returns Breakdown

Scenario #1: $100,000 invested in Year 1 with no further trading during the period and assumed death in Year 30. The after-tax value equals $1 million at death in Year 30.  Return required: 8% 

Scenario #2: $100,000 invested in Year 1 with 100% annual trading turnover thereafter. Short-term gain taxes are paid annually at 40.8%. No management fees or incentive fees are charged. The after-tax value equals $1 million at death in Year 30.  Return required: 13.5% 

Scenario #3: $100,000 invested in a hedge fund with a 2% management fee, 100% annual trading turnover, and short-term gain taxes paid annually at 40.8%. No incentive fees are charged. The after-tax value equals $1 million at death in Year 30.  Return required: 17.25% 

Scenario #4: $100,000 invested in a hedge fund with a 2% management fee, 100% annual trading turnover, and short-term gain taxes paid annually at 40.8%. A 20% incentive fee is charged only on net new highs in market value. The after-tax value equals $1 million at death in Year 30. Return required: 22.4% 

The next time your buddy is bragging about the hedge fund he owns with its sexy returns, I hope you remember the math presented above.  

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