The Economist Once More Writes About The Hedge Fund Mirage

I am once again indebted to The Economist for writing about my book and noting some of the points I made about hedge funds’ poor performance. On January 7 they covered it in the Buttonwood column, and this weekend they once again discussed the issues I raised. They are performing a public service by highlighting some important concerns for investors.

Why There Are Too Many Hedge Funds

Last week I gave the second in a series of presentations I’ve been invited to make to the Tiger 21 group. Tiger 21 is an association of wealthy entrepreneurs that engage in “peer-to-peer” learning on issues that they have in common. Criteria for membership include a minimum investable assets of $30 million and payment of $30K in annual dues. Membership is by invitation only. The members have diverse backgrounds and sources of wealth, but one thing that brings them together is the search for unbiased investment advice. Most if not all members are regularly subject to marketing pitches from well-intentioned bankers seeking their investment in hedge funds, private equity and other illiquid, long-lived investments with their promise of recurring fee revenue for the banks over many years.

As I run through the basic Math of my book and explain why hedge fund investors in aggregate have not done that well, invariably an expression of understanding passes across the room as the audience grasps how one-sided the game can be. Generally groups like this have not made money in hedge funds, but they often blame poor manager selection and don’t focus on the structural disadvantages (fees, lack of transparency and illiquidity) that are stacked against them. They have an uneasy feeling that hedge funds haven’t been as good as is popularly believed, but the knowledge that the only group that’s made money is the managers is invariably met with much cynicism as countless meetings with hedge fund industry proponents are recalled.

Most of the Tiger 21 members I have met are self-made, and they well understand the profit motive and how to exploit a market opportunity. But even this unapologetically capitalist crowd is taken aback as the staggering imbalance between results for the clients compared with the managers sinks in. Perhaps never before in history has the inclusion of a diversified hedge fund portfolio been so challenged as an integral part of the ultra high net worth approach to investing.

The UK-based hedge fund lobbying group the Alternative Investment Manager’s Association (AIMA) was moved by my book to commission a defence of their paymasters by KPMG. It was somewhat misleading, in that its support of hedge funds was based on the 9% return that an investor starting in 1994 would have earned from an equally weighted portfolio, rebalanced every year. Of course no such investor plausibly exists, and holding an equally weighted portfolio isn’t possible for all investors (since hedge funds are not equally sized). And in 1994 although hedge fund investors did well there weren’t many of them. The industry was very small. If you’re going to recommend hedge funds why not consider how ALL the investors have done and not just a hypothetical one that was lucky enough to earn the good returns of the 90s (when hedge funds were a far better deal for clients). I posted my response shortly after KPMG’s report was published.

Meanwhile, where are all the happy clients who should be voicing their agreement with AIMA’s marketing brochure? Why is it that the only people advocating hedge funds are the people whose job it is to promote them in the first place? Has AIMA sensibly not sought endorsements from actual investors? Or have they tried and failed? Have they struggled to find any happy clients (although I could help them out as I know quite a few; it’s not that nobody made money, just the aggregate).

The Capital Asset Pricing Model (CAPM), that cornerstone of modern financial theory, teaches that a diversified portfolio is the best way to invest in any asset class since the market doesn’t reward idiosyncratic, or stock-specific risk. This is the most efficient way to achieve the systematic return of the asset class the investor is targeting. But it’s based on the not trivial assumption that the systematic return, or in other words the return on that particular market, is something worth having. Since the average $ invested in hedge funds would have been better in treasury bills, the thoughtful hedge fund investor might be advised to sprint away from anything that promises the average industry return. In my opinion the only way to justify hedge fund investments is if you’re good at selecting hedge fund managers.

You can invest in stocks and not be a stock picker; if you can’t pick hedge funds stay away. And the corollary is that IF you are skilled at picked hedge funds then diversification is not your friend. The more hedge funds you have the less likely you are to do any better than average. In my experience, the people who are happiest with their hedge fund investments only have a couple. The problem for the hedge fund industry is that two hedge funds should of course command a far smaller percentage of an investor’s portfolio than a more diverse selection. We wouldn’t need such a big hedge fund industry. That is how investors should use hedge funds. Will anyone else in the industry tell them?

The Venture Capital Mirage

The Kauffman Foundation in Kansas City, MO is to be commended for the open manner in which they’ve shared the results of their own venture capital (VC) investing. In a remarkably candid appraisal that covers twenty years of experience, the authors reveal that much of the conventional wisdom about this area of private equity is wrong. Larger funds reliably underperform smaller ones; fees eat up disproportionate chunks of performance; investors too easily sign up for second tier managers in order to deploy capital that’s “burning a hole in their pockets” while top tier funds seem to be the only way to justify the risk (as long as they don’t grow too big).

The authors, who include CIO Harold Bradley, note with irony that while venture capital funds search tirelessly for new business models and innovation there has been remarkably little of this in the vc industry itself. Fees of 2&20 with limited transparency around GP compensation have prevailed with oddly little change. The report also notes that while vc funds demand complete transparency around the financials and compensation of the companies in which they invest, they generally refuse to provide anything similar to their own investors.

Kauffman reports that only 20 out of their 100 vc funds beat a public equity market equivalent by more than 3% (a modest reward for illiquidity) and that half of those began investing prior to 1995. They also find that the “J-curve” (which holds that early negative returns quickly improve as investments mature) doesn’t really exist.

In many ways what’s wrong with vc investing is similar to what’s wrong with hedge funds. Their findings echo my book, The Hedge Fund Mirage. Too much money chasing returns; LPs that don’t press for better terms. Poor transparency.

The Kauffman Foundation should be applauded for their open approach to discussing issues that demand more attention. I hope their step forward provokes other investors to similarly examine their own results.

Interview with Pension Pulse

Here’s an interview I did with this Montreal-based website that reports on hedge funds for Canadian institutional clients.

Talking Hedge Funds on Bloomberg

Click here to see a spot I did today discussing the hedge fund lobbying group, AIMA, and their recent report promoting hedge funds. They are a soft target.

The Hedge Fund Lobbyists Fight Back

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.


The Hedge Fund Debate

Last night’s event organized by Catalyst Financial Partners was a great success. I was paired in a debate with an old friend Peter Fell, with whom I traded interest rate swaps back in the 80s when we were both at Manufacturers Hanover Trust (Manny Hanny). The question posed was “The Eroding Profitabilty of Hedge Funds”. Peter (now with Kenmar) gamely took what I felt to be the much harder side (i.e. defending the hedge fund industry) and it was capably moderated by Brenda Mauro of Trident Fund Services. Peter was not distracted by the autographed copy of my book that I shamelessly thrust into his hands moments before we began, and while there may be varying opinions on the future of hedge funds most would agree that investors will need better terms and results if the industry is to prosper.

Today KPMG released a report on hedge funds in partnership with AIMA, the UK-based hedge fund lobbying group. They evidently felt moved to set the record straight after the relentless battering hedge funds have received in the financial media of late. I am grateful that they have made such an effort – it’s given me something to write about.

The Eroding Profitability of Hedge Funds

On Monday I shall be taking part in a debate on this topic on Monday evening in NY with my friend Peter Fell, from Kenmar, at The Harvard Club. I am looking forward to the opportunity to discuss with other investors how hedge fund clients might improve upon the frankly abysmal results that the industry has delivered. Fees, lack of transparency, gates and other elements all combine to ensure that whatever profits hedge funds generate are taken up in fees.

Investors deserve far better than they have received, and I’m looking forward to an entertaining and lively discussion.

HedgeWorld Chicago 2012

I have been invited to give the Keynote Address at this industry gathering in June. I am looking forward to the opportunity to meet with hedge fund industry professionals and discuss how investors can achieve better results than they have in the past.