Must Rich Investors Keep It Simple?

Burton G. Malkiel has a message for high-net-worth investors in the new book he's written with Charles Ellis: KISS.

Keep it simple, stupid! Stick to a sensible allocation of index funds.

Whoa there! Isn't the lure of double-digit returns from hedge funds and other alternative investments essential when you're marketing investment services to the wealthy?

The lure seems necessary. But the above-market returns are questionable. As this Breaking Views column in the NY Times notes, "hedge fund index returns still flatter the average fund …."

One index, for example, shows the average hedge fund beating the annual return on the S&P by about four percentage points since 1990. Almost nobody, including Malkiel, believes it. The index tracks only funds that choose to report their returns, and survivorship bias is a real problem because hedge funds die at twice the rate of mutual funds:

Based on Mr. Malkiel’s studies and other academic work, hedge fund investors should probably assume that reported industrywide returns are really as much as four percentage points lower, which makes hedge fund managers look much less special.

O.K. Let's suppose the well-heeled investor who puts money into the average hedge fund will get no more than a market rate of return. Couldn't investing in hedge funds still be a win-win proposition?

• Managers of hedge funds win because they make umpteen times the bucks earned by overseers of index funds.
• Investors in hedge funds win, on average, because they receive a market rate of return plus bragging rights.

Nobody ever scored points at the club by boasting, "My investment guy knows somebody at Vanguard. He got me into a couple of index funds."

Even if hedge funds don't beat the market on average, surely they pay social-networking dividends.