Hedge Fund Performance

From this recent Wall Street Journal article on hedge fund performance:

Chart: Hedge Funds vs Mutual Funds vs S&P 500

- The average hedge fund rose 4% this year through August 9th.

- The S&P 500 had a total return of 20% over the same period of time.

- The average hedge fund also underperformed the markets last year with an 8% gain versus 16% total return for the S&P 500.

- Less than 5% of the hedge funds outperformed the S&P 500 so far this year.

- Roughly 25% of the funds posted absolute losses.

Well, at least they're not actually managing all that much money...

According to the article, these 708 hedge funds are now managing something $1.5 trillion including long and short positions.

$ 1.5 TRILLION

Well, at least the typical fees they charge aren't too unreasonable...

2% of total assets as a management fee plus 20% of profits.

Incredible.

So last month the Securities and Exchange Commission voted to lift an 80-year restrictions on advertising by hedge funds. From this Barron's article:

"...the government, which has been tightening rules for cigarette advertising for decades, apparently has determined that, while the latter may be harmful to your health, it's okay to tout things that have proven deleterious to the wealth of the well-to-do."

The article later asks, with an expensive "product that turned $10 million into $9 million, while the off-the-rack generic grew that into $14 million" to sell, what should an ad agency do?

The article suggests that maybe a focus on prestige instead of performance might work.

"If you invest in hedge funds, it means you're rich enough to afford to lose money. Nothing says wealth like handing your dough to a big-name hedgie and watching it shrivel."

That Barron's article also suggested some possible ads...

'You have your own chef and a personal trainer. You don't fly commercial. You pay way too much for everything. And you don't have a hedge fund?'

'In these days of rising taxes, it's more important than ever to plan. Our hedge fund is a perfect offset to your capital gains.'

'A boat is a hole in the water where you pour money. You already have a yacht. So buy our hedge fund.'

In the article, Barron's offers some other ad possibilities as well.

This Bloomberg Businessweek article makes its case against hedge funds in a slightly less subtle way.

Bloomberg Businessweek: Hedge Funds Are For Suckers

In this Bloomberg article, George Soros said hedge funds can't beat the market because of fees.

Advertising for these investment vehicles are supposed to remain limited to accredited investors. We'll see how that works out. In any case, this might be one of the better examples where being excluded from an exclusive club should generally be considered a happy outcome.

Of course, there's no doubt some very good hedge funds out there.

This chart does show that the "Hedge Fund VIP Basket" did outperform the S&P 500. I suppose that implies to some that being in this even more exclusive club is the way to go.

Yet I suspect picking the winning long-term managers beforehand will continue to be not necessarily all that easy.

It's worth mentioning that such short time frames don't reveal much of anything in terms of relative or absolute performance.

Also, figuring out how much risk is being taken is critical and not always easy to do. Returns are easily quantified. Risks are not (and is certainly not measured by beta).

So much longer time frames are needed to make a sound judgment. That's naturally part of the problem when it comes to picking who can be trusted managing funds. Practically speaking, not enough have the 20-30 years of performance that ideally could be used as a basis for judging performance.

It's also worth noting that -- even if hedge funds did tend to outperform -- all these fees, in aggregate, are simply a siphoning of funds that would otherwise be savings and investment. Jeremy Grantham once made the point that the frictional costs resulting from fees being charged actually "raid the balance sheet" of investors.

I think Grantham gets it just about right.

In any case, at least to me, it all seems a terrible way of getting the important function of capital formation and development done.

Unfortunately, it has evolved in this way. I certainly don't blame anyone who does it for an honest living. They are simply going where the money is.

That doesn't mean it's serving us all that well overall in its current form.

That doesn't mean it isn't costly well beyond the explicit fees.

Considering the interests involved and other forces at work (including very powerful psychological ones), it's unlikely there'll be material changes anytime soon.

It would be different if hedge funds remained a small niche in the capital markets but, well, last time I checked $ 1.5 trillion is real money.

And that's only a subset of the industry. According to this article there are now roughly 10,000 hedge funds. They manage something like $2.3 trillion.

Will that number become significantly higher years down the road?

Will the lifting the advertising restrictions have a big impact?

Time will tell.

Adam

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