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.

I’ll be making an appearance with two other hedge fund authors Jack Schwager and Steve Drobny, discussing the state of the hedge fund industry next month.

http://www.hedgefundintelligence.com/Article/3102473/Market-wizards-or-masters-of-mirage-Noted-authors-Schwager-Lack-and-Drobny-to-discuss-at-Symposium.html

There are some signs that the hedge fund industry is moving towards a more appropriate capital base. Leo Kolivakis, who covers hedge funds and other classes of investment for Canadian pension funds, noted that outflows from hedge funds have picked up recently. Mediocre returns delivered at great expense for several years may be starting to focus attention on the $2TN size of the industry and perhaps cause investors to question their previously held return expectations. The Alternative Investment Managers Association (AIMA) in London, the lobbying group for the industry, must be surprised. They keep issuing reports and analyses telling everybody how good hedge funds have been, although this view seems at odds with the actions of departing investors.

Of course some hedge fund managers are taking the initiative and returning capital to clients, such as Louis Bacon. The industry could use more managers who recognize the prevailing limits on their own strategies. But overall, the article finds that assets are s23% lower than their peak just prior to the financial crisis four years ago.

The problem with the structure of AIMA’s analysis is that it doesn’t contemplate that the industry could ever be overcapitalized, whereas that is what empirical evidence strongly suggests. Fortunately, it’s beginning to look as if hedge fund investors are questioning AIMA’s orthodoxy. 2012 will likely be the 10th straight year in which a simple 60/40 stocks/bonds portfolio has beaten the broad hedge fund industry averages. In a win for the little guy, it’s turning out that investors with quite modest means that render them unqualified to be a “sophisticated” investor (and therefore eligible to be a hedge fund client) are quite easily and cheaply able to outperform investors who have signed up with the Masters of the Universe.

A few weeks ago the London-based Alternative Investment Management Association (AIMA) issued a “comprehensive rebuttal” of my book, The Hedge Fund Mirage. AIMA’s mission is to promote the hedge fund industry, so one might anticipate a breathless endorsement of their paymasters, and in this they did not disappoint.

 
I didn’t bother commenting on their report because it didn’t receive any mainstream financial press coverage. Few serious journalists took them seriously. And in any case, AIMA’s clients (i.e. hedge funds) have (unfortunately for their clients) been helpfully providing further empirical support for my assertion that $2 trillion in AUM is more than they can usefully manage by generating consistently mediocre results at great expense.

 
But Jonathan Ford in today’s FT rightly questions whether the hedge fund industry as a whole is over capitalized. Mr. Ford is providing a far more useful perspective for consideration by those pension funds cramming ever more assets into hedge funds than the industry’s increasingly ineffective and far from impartial lobbyists.

The title isn’t my creation, but is rather the work of Michael Edesess, PhD, CIO of Fair Advisors (an investment firm) and author of The Big Investment Lie (which I am currently reading). Michael just posted a review of my book, and he does an excellent job of summarizing the highlights and adding his own commentary. I had a most interesting chat with him a couple of weeks ago when he was writing the review from his office in Hong Kong.