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The Problem With Hedge Funds

By Simon LackMarket OverviewJun 19, 2012 11:00AM ET
www.investing.com/analysis/the-problem-with-hedge-funds-127012
The Problem With Hedge Funds
By Simon Lack   |  Jun 19, 2012 11:00AM ET
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Last week I gave the second in a series of presentations to the Tiger 21 group, which is a group of wealthy entrepreneurs that engage in “peer-to-peer” learning on issues they have in common. Criteria for membership include minimum-investable assets of $30 million and annual dues of $30K. Membership is by invitation only. The members have diverse backgrounds and sources of wealth, but one thing that brings them together is the search for unbiased investment advice. Most if not all members are regularly subject to marketing pitches from well-intentioned bankers seeking their investment in hedge funds, private equity and other illiquid, long-lived investments with the promise of recurring-fee revenue over many years.

Fund Managers Win
As I run through the basic math and explain why hedge fund investors in aggregate have not done that well, invariably an expression of understanding sweeps across the room as the audience grasps how one-sided the game can be. Generally groups like this have not made money in hedge funds, citing poor management and a lack of focus on structural disadvantages (fees, lack of transparency and illiquidity) that are stacked against them. They have an uneasy feeling that hedge funds haven’t been as good as is popularly believed, but the knowledge that the only group that’s made money is the managers is invariably met with much cynicism as countless meetings with hedge fund industry proponents are recalled.

Most of the Tiger 21 members I have met are self-made, and they well understand the profit motive and how to exploit a market opportunity. But even this unapologetically capitalist crowd is taken aback as the staggering imbalance between results for the clients compared and the managers sinks in. Perhaps never before in history has the inclusion of a diversified hedge fund portfolio been so challenged as an integral part of the ultra high net worth approach to investing.

Hypothetical Analysis
The U.K.-based hedge fund lobbying group the Alternative Investment Manager’s Association (AIMA) was moved by my book to commission a defence of their paymasters by KPMG. It was somewhat misleading, in that its support of hedge funds was based on the 9% return that an investor starting in 1994 would have earned from an equally weighted portfolio, rebalanced every year. Of course no such investor exists, nor could they since holding an equally weighted portfolio isn’t possible to all investors (since hedge funds are not equally sized). And in 1994 -- although hedge fund investors did well -- there weren’t many of them. The industry was very small. If you’re going to recommend hedge funds why not consider how all investors have done and not just a hypothetical one that was lucky enough to earn the good returns of the 90s (when hedge funds were a far better deal for clients). I posted my response shortly after KPMG’s report was published.

Meanwhile, where are all the happy clients who should be voicing their agreement with AIMA’s marketing brochure? Why is it that the only people advocating hedge funds are the people whose job it is to promote them in the first place? Has AIMA sensibly not sought endorsements from actual investors? Or have they tried and failed? Have they struggled to find any happy clients (although I could help them out as I know quite a few; it’s not that nobody made money, just the aggregate).

Diversity, Diversity, Diversity
The Capital Asset Pricing Model (CAPM) -- that cornerstone of modern financial theory -- teaches that a diversified portfolio is the best way to invest in any asset class since the market doesn’t reward idiosyncratic, or stock-specific risk. This is the most efficient way to achieve the systematic return of the asset class the investor is targeting. But it’s based on the not-trivial assumption that the systematic return, in other words the return on that particular market, is something worth having. Since the average dollar invested in hedge funds would have done better in treasury bills, the thoughtful hedge-fund investor might be advised to sprint away from anything that promises the average-industry return. In my opinion the only way to justify hedge-fund investments is if you’re good at selecting hedge-fund managers.

You can invest in stocks and not be a stock picker; if you can’t pick hedge funds stay away. And the corollary is that if you are skilled at picking hedge funds, then diversification is not your friend. The more hedge funds you're in, the less likely you are to do any better than average. In my experience, the people who are happiest with their hedge-fund investments only have a couple. The problem for the hedge-fund industry is that two hedge funds should of course command a far smaller percentage of an investor’s portfolio than a more diverse one. We don’t need such a big hedge-fund industry. That's how investors should invest in the funds. Will anyone else in the industry tell them?
The Problem With Hedge Funds
 

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The Problem With Hedge Funds

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