Are Hedge Funds Ever Expensive?

Yesterday I sat through presentations at a conference on alternatives sponsored by Investment News. The participants were largely financial advisers looking for alternative sources of investment income for their clients’ portfolios given the poor prospects in fixed income currently. This is everybody’s problem and I certainly can sympathize since we do the same thing ourselves every day.

I was struck by one presentation from a large consulting firm. They produced the familiar chart showing long term returns on hedge funds compared with other asset classes and used data going back as far as 1990. No surprise that they recommend a sizeable (20-30%) allocation to hedge funds. There was no consideration given to the miniscule size of the industry back in the early 90s when returns were good, so in their statistical analysis each year receives equal importance in arriving at their result.

It occurred to me that this type of promotion of hedge funds doesn’t incorporate any evaluation of whether hedge funds are cheap. Every other asset class in a portfolio lends itself to at least an opinion of whether return prospects are good or not. For equities (both public and private) P/E ratios and growth prospects for the market can be examined; in Fixed Income yields and spreads can be compared with other assets, and even in real estate you can look at cap rates. But hedge funds don’t lend themselves to any of this type of analysis. For the proponent of hedge funds, it’s ALWAYS a good time to invest. Past returns over many years are what they use to predict the future, since hedge funds can’t be cheap on a price/book basis or offer a compelling current yield. Such a view would only change (and even then probably too slowly) in the face of continued poor returns (rather like the past several years). What a thoughtless approach.

Meanwhile, Blackstone has launched a fund to buy up the stakes in hedge fund managers owned by banks and others that are looking to exit, either for regulatory reasons or because return prospects are poor. In effect it’s a fund to take out the providers of seed capital. Quite innovative, it’ll be interesting to see how they do.