My friend Josh Friedlander, Editor at Absolute Return, has written a very good essay in the Hedge Fund Intelligence Global Review 2013. Unlike most journalists covering the sector who offer uncritical praise of their subjects, Josh asks some very pertinent questions about the future of the hedge fund industry. He’s asking the right questions. Hedge fund investors would benefit from more critical thinking like this.
This is the title of a “mini-book” by William Bernstein. I just came across a review of it by Larry Swedroe. I haven’t yet read Mr. Bernstein’s book (I just ordered it this morning) but Swedroe’s review caught my attention. It looks as if a three factor analysis of hedge fund returns has arrived at the same conclusion I did in my book – that hedge funds used to be great, that early investors did well, and that the industry today is overcapitalized.
David Hsieh, Professor of Finance at Duke’s Fuqua School of Business suggested that alpha is finite, and that’s why today’s hedge fund investors will continue to be disappointed. Makes perfect sense to me. So now we have some real academics weighing in on the debate, as opposed to the pseudo-variety hired and paid for by AIMA in London. Mediocre returns delivered at great expense continue, providing additional support for the critics.
My thanks to Joshua Rogers, a contributor to Forbes, for wading in to the debate on hedge funds. You can read his post here, and scroll down to see my comment in response.
The Economist, without doubt my favorite weekly magazine (or newspaper as they refer to themselves) has brought its clear thinking and analytical skills to hedge fund returns. As usual they’ve provided a balanced perspective that includes important points. They note the poor decade hedge funds have had relative to a simple 60/40 stocks/bonds portfolio. They suggest that most likely hedge fund fees have exceeded the returns earned by investors (in fact fees have completely swamped overall returns for investors as I’ve noted in my book and on this blog). “The average hedge fund is a lousy bet” they note, and this is true. There are great hedge funds and happy clients, but this is not the norm.
The vast majority of hedge fund professionals have sensibly stayed away from this debate. Defending a diversified portfolio of hedge funds as vital to an institutional portfolio requires nimble debating skills given the absence of factual data in support. And I continue to find many open minds among hedge fund allocators and investors. The industry has drawn people with highly developed commercial skills and most recognize well the need to transfer more of the investment skill that does exist to their clients with less drag from high fees and mediocrity. I have no doubt that business models will evolve and improve in response to the sorry decade of results. Hedge funds will not disappear. The many problems with the existing structure will eventually be solved to the benefit of the clients.
However, Tom Schneeweis, a Finance professor at UMass Amherst, has offered some criticisms of my book, including describing it recently as, “…baby hedge fund analysis 101 at best.” I imagine among the Ivory Tower crowd this must represent quite an insult. Further demonstrating Mr. Schneeweis isn’t overly reliant on hedge fund returns to provide a comfortable retirement, he asserts that investors should be indifferent to fees. He says that, “…if an investor is receiving a positive benefit from owning a product, the net profit to the creators of the product may be regarded of secondary concern.” That may pass for accepted wisdom in the classroom, but out in the real world investors care deeply about the fees they pay. The long-standing trend towards greater disclosure of fees in Finance is a natural response. Mr. Schneeweis sounds like someone who hasn’t spent much of his own money on hedge fund fees, just other people’s.
Fortunately, The Economist with its substantially wider readership is providing investors with more thoughtful advice.
Amazon asked me to write a piece for their blog promoting certain books, so I was happy to oblige. You can find it here.
The entire eastern seaboard of the United States is waiting tentatively for Hurricane Sandy’s arrival. Our patio furniture has been safely stored indoors. Batteries and candles are well supplied in anticipation of the inevitable power loss, and with preparations done we wait for the slowly arriving worst storm many of us have ever seen. So naturally, I turned to Gretchen Morgensen’s article in the New York Times today (“The Perils of Feeding a Bloated Industry“). Gretchen focuses on the costs of active money management and questions whether society has received much benefit from the increasing share of GDP that is represented by the financial services industry. It’s a worthy question and one that society has a right to ask given events of the past few years. In this she highlights a recent academic paper (“The Growth of Modern Finance” by Robin Greenwood and David Scharfstein) and in clicking on the hyperlink to this paper I was fascinated to see included an estimate of hedge fund fees.
Readers of my book The Hedge Fund Mirage will be familiar with my assertion that fees had consumed fully 98% of the investor profits in excess of t-bills through 2010. I even posted a pie chart illustrating the fact on my blog a few months ago. If you look at the chart you’ll note that the 2% sliver of pie denoting the clients’ share only lasts through 2010. Including 2011 wipes it out, but since I couldn’t conceive of a negative slice of pie in two dimensions the schematic had to run only through 2010.
The Alternative Investment Managers Association (AIMA) in London, whose sorry task it is to defend past practices of their paymasters in the hedge fund industry, has made a couple of attempts to respond to the chief finding of my book (that all the money ever invested in hedge funds would have been better off in treasury bills), but even AIMA has not attempted a robust defense of the 2 & 20 fee structure. AIMA’s recent paper was effectively demolished here. They do rather lamely offer that fees have amounted to 3.5% per annum, and even though that sounds high to most people it’s based on the same flawed structure used throughout their paper which relies on a hypothetical investor with an equally weighted portfolio started in 1994. Whether such an investor actually exists or not is another matter – I think it’s more realistic to measure how ALL the money has done, and in 1994 while investors did well there weren’t that many of them.
So I was interested to note that in the Greenwood and Scharfstein paper referenced above, hedge fund fees are found to be similar to my numbers. For example, the paper states that hedge fund fees reached $69BN in 2007, remarkably close to the $70BN estimate that I found and included in my book. Greenwood and Scharfstein weren’t focused on hedge fund fees necessarily in their paper, and they make a good point that active management can lead to more efficient security pricing and greater diversification which ultimately lowers the cost of capital for companies (you’ll have to read their paper to see why this makes sense, but I think it does). So they’re not highly critical of hedge funds (although they feel fees are too high) and they reach a similar place to me on fees.
But then I came across an earlier paper by Kenneth French in the 2008 Journal of Finance (“Presidential Address: The Cost of Active Investing“) and although Kenneth French focuses just on equity long/short hedge funds he estimates that the average annual drag of fees from 1996-2007 is 6.5%, virtually double what AIMA rather hopefully suggested. In fact, if I’d used his methodology I would have come up with even higher estimates in my book.
If some observers feel I’ve treated hedge funds too kindly on the fee issue, I can now understand why. It seems academic papers are all around showing that it’s been at least as bad as I’ve described.