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.

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.

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

Jim Stewart in the New York Times has noted the poor performance of many large university endowments, and in the process questions their large allocations to alternatives. Hedge funds figure prominently for many of them, and their investment committees are learning the hard way that uncorrelated returns are not unlimited, and that the hedge fund industry is overcapitalized. Jim is pursuing an important story and one that ought to make all institutional investors stop and reconsider what passes for conventional wisdom – a sizeable allocation to hedge funds.

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.

I thought this was a pretty balanced and investor-oriented piece:

http://www.finalternatives.com/node/21480

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.

From Felix Salmon’s examination of AIMA’s latest attempt to counter the criticisms of the hedge fund industry in my book. Felix is far more eloquent than I ever could be in assessing AIMA’s report. It’s well worth reading his analysis.

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.

Modern financial theory holds that a diversified portfolio of securities is the most efficient way for an investor to access an asset class. Idiosyncratic risk, the risk associated with an individual stock say, can be diversified away and therefore theory holds that investors don’t achieve any additional return for holding concentrated portfolios of their favorite stocks. It’s an idea that makes a lot of intuitive sense. Consequently, you can invest in equities and possess no particular stock-picking skill by using an index fund. Hundreds of billions of dollars are invested passively in this way. Based on many decades of performance from public equities (although admittedly the last decade was no walk in the park) this is a sound strategy.

Using the same construct with hedge funds produces a different result. A key underlying assumption in the “diversification is good” approach is that the underlying asset class has a positive return. However, as I show in my book The Hedge Fund Mirage, if all the money ever invested in hedge funds had been in treasury bills instead, the investors would have been better off. The average hedge fund $ generated a negative return with respect to the risk-free rate. There are great hedge funds and happy clients, but these are not the norm. Since I wrote my book hedge funds have continued to provide empirical support for my findings. YTD performance for the HFRX Global Hedge Fund Index is 1.2% through June – actually outpacing treasury bills (which yield approximately 0%) but for the tenth straight year lagging a simple 60/40 stocks/bonds portfolio.

Since hedge funds in aggregate have been a bad investment, the only way to win as an investor is to be better than average at picking managers. Some people are. But since diversification is intended to draw you towards the average return, and the average return is in this case not something you want, the rational use of hedge funds in an investment portfolio is to select only two or three where you have insight and high conviction. Adding more funds creates more diversification, which for a hedge fund investor is a bad thing.

Some of the smartest people in the hedge fund industry are the hedge fund managers themselves. You’ll rarely hear them advocating a diverse portfolio of hedge funds. They already understand the mediocrity and lack of return persistence so prevalent amongst their peers. And often the happiest clients are those who don’t have many hedge funds, but made a few good choices with a small part of their portfolio. For if a diversified hedge fund portfolio is bad, so is a large allocation to hedge funds. A 1-2% allocation to two or three funds takes the best of what hedge funds have to offer. Hedge fund returns have steadily deteriorated as assets have grown, just as is the case with individual funds.

But the consultants and advisors who promote a diversified portfolio of hedge funds as an important component of an institution’s overall portfolio are misusing the Capital Asset Pricing Model. A diversified hedge fund portfolio is The Dumbest Idea in Finance.