Hedge funds have received quite a battering in the financial press of late. Persistently disappointing results have rightly drawn attention to the high fees, opaque strategies and limited liquidity that characterize much of the industry. My recent book, The Hedge Fund Mirage, has helped promote a long overdue debate about how investors should access some of the most talented money managers around. Although in aggregate all the money ever invested in hedge funds would have been better off in treasury bills, there are and probably always will be fantastic managers and happy clients. However, in recent years these have increasingly become the exception.

Although this description of hedge funds is provocative, much of the industry has sensibly kept its head down. In fact, few managers promote the industry and most are focused simply on their hedge fund. Many insiders readily acknowledge the disappointing results of the past with little surprise. However, the Alternative Investment Managers Association (AIMA), a UK-based lobbying group, has come to the defense of hedge funds. They recently commissioned a report titled “The value of the hedge fund industry to investors, markets, and the broader economy” in partnership with KPMG and the Centre for Hedge Fund Research at Imperial College, London. Although the paper concludes by noting the substantial social benefits of hedge funds such as employing 300,000 people globally, generating £3.2 billion in UK tax revenues and their stewardship of assets for “socially valuable investors”, I’m just going to focus on whether hedge funds have been a good deal for their clients.

Asset weighted returns, or the return on the average dollar, are poor. My analysis shows in aggregate treasury bills were a better bet. I found this to be the case only through 2010, and while some may torture the data to produce modestly different results, 2011 was the second worst year in history for hedge funds and should pretty much end the performance discussion.

Average annual returns are good. The KPMG/AIMA study referenced above finds that an investment in an equally weighted portfolio of hedge funds starting in 1994 (as far back as data can reasonably be sourced) generated an annual return of over 9%, handily beating stocks, bonds and commodities. Returns in the 90s were good for the small number of investors participating. The 9% figure is the average over 18 years. The question is whether the 12.4% return from 1994-98 is just as important as the 2.6% return from 2007-11, when the industry was twenty times as big.

Hedge fund investors know that small hedge funds outperform big ones; they also know that most big hedge funds they look at performed better when they were smaller. What is true for most individual funds is true for the industry as a whole. Using an equally weighted portfolio to represent returns will be upwardly biased for this reason. An equally weighted S&P500 has outperformed the cap-weighted version too. While equal weights might be a good way to invest, it’s clearly not a strategy available to all investors, since hedge funds are not equally sized. The return enjoyed by a hypothetical investor who started in 1994 investing equal dollars in each hedge fund isn’t representative of the average investor and is more marketing pitch than analysis.

Given how poorly actual hedge fund investors have done how could new investors possibly think that they will make money going forward? To do so they must accept the returns of a hypothetical investor who invested equal dollar amounts in hedge funds and maintained those equal investments in each hedge fund every year since 1994!  As I point out in The Hedge Fund Mirage performance was better both for the industry when it was smaller and for individual hedge funds when they were smaller.

Fees are egregious by any measure. The 2% management fee and 20% incentive fee have resulted in an enormous transfer of wealth from clients to the hedge fund industry. My analysis shows that pretty much all the profits earned by hedge funds in excess of the risk free rate have been consumed by fees. Anybody with a spreadsheet can calculate this using publicly available data without great difficulty. KPMG/AIMA concede that hedge funds have garnered 28% of investor profits, although treasury bills averaged 3.2% over this same period so even using their own numbers reveals that in fact fees took 64% of the returns in excess of the risk free rate. This is for the hypothetical, equally weighted portfolio begun in 1994. It also ignores netting – winning hedge funds charge an incentive fee whereas losing managers don’t offer a rebate. By treating the industry as one giant hedge fund it ignores the fact that whenever an investor holds some losing hedge funds his effective incentive fee will be higher than the typical 20% of profits. Without doubt, for the actual universe of investors whose hedge fund investments performed worse than the hypothetical investor, fees have consumed all the profits.

Those who think the first five years of hedge fund history are as important as the last five will hold out hope for that 9% historic return. Even a 7% return on hedge funds, the typical expectation of many investors, represents $140 billion in annual profits (net of fees, naturally) on the approximately $2 trillion in AUM. It’s a figure the industry has never generated other than in 2009 following a $450 billion shellacking in 2008. Generating $140 billion of uncorrelated, absolute return every year (after fees) has proved to be a bridge too far. Hedge funds are over-capitalized.

AIMA would better serve its constituents by promoting transparency, improved governance and fee structures that are commensurate with a world of near zero interest rates. Instead the 2&20 crowd has spent some of their fees on a glossy marketing brochure. By promoting the status quo they’re ignoring the experience of hedge fund clients, who are struggling with the reality of continued poor results delivered at great expense.  Institutions such as Allstate Insurance, whose global head of hedge funds Chris Vogt recently said, “This is a make-or-break year for hedge funds” will increasingly force change on the hedge fund industry, to the undoubted benefit of the clients hedge funds are supposed to serve.

In case anyone’s forgotten, this is how fees were carved up from 1998-2010.

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