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 information provided is for informational purposes only and investors should determine for themselves whether a particular service, security or product is suitable for their investment needs. The information contained herein is not complete, may not be current, is subject to change, and is subject to, and qualified in its entirety by, the more complete disclosures, risk factors and other terms that are contained in the disclosure, prospectus, and offering. Certain information herein has been obtained from third party sources and, although believed to be reliable, has not been independently verified and its accuracy or completeness cannot be guaranteed. No representation is made with respect to the accuracy, completeness or timeliness of this information. Nothing provided on this site constitutes tax advice. Individuals should seek the advice of their own tax advisor for specific information regarding tax consequences of investments. Investments in securities entail risk and are not suitable for all investors. This site is not a recommendation nor an offer to sell (or solicitation of an offer to buy) securities in the United States or in any other jurisdiction.
References to indexes and benchmarks are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in an index and do not reflect the deduction of the advisor’s fees or other trading expenses. There can be no assurance that current investments will be profitable. Actual realized returns will depend on, among other factors, the value of assets and market conditions at the time of disposition, any related transaction costs, and the timing of the purchase. Indexes and benchmarks may not directly correlate or only partially relate to portfolios managed by SL Advisors as they have different underlying investments and may use different strategies or have different objectives than portfolios managed by SL Advisors (e.g. The Alerian index is a group MLP securities in the oil and gas industries. Portfolios may not include the same investments that are included in the Alerian Index. The S & P Index does not directly relate to investment strategies managed by SL Advisers.)
This site may contain forward-looking statements relating to the objectives, opportunities, and the future performance of the U.S. market generally. Forward-looking statements may be identified by the use of such words as; “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential” and other similar terms. Examples of forward-looking statements include, but are not limited to, estimates with respect to financial condition, results of operations, and success or lack of success of any particular investment strategy. All are subject to various factors, including, but not limited to general and local economic conditions, changing levels of competition within certain industries and markets, changes in interest rates, changes in legislation or regulation, and other economic, competitive, governmental, regulatory and technological factors affecting a portfolio’s operations that could cause actual results to differ materially from projected results. Such statements are forward-looking in nature and involves a number of known and unknown risks, uncertainties and other factors, and accordingly, actual results may differ materially from those reflected or contemplated in such forward-looking statements. Prospective investors are cautioned not to place undue reliance on any forward-looking statements or examples. None of SL Advisors LLC or any of its affiliates or principals nor any other individual or entity assumes any obligation to update any forward-looking statements as a result of new information, subsequent events or any other circumstances. All statements made herein speak only as of the date that they were made. r
Certain hyperlinks or referenced websites on the Site, if any, are for your convenience and forward you to third parties’ websites, which generally are recognized by their top level domain name. Any descriptions of, references to, or links to other products, publications or services does not constitute an endorsement, authorization, sponsorship by or affiliation with SL Advisors LLC with respect to any linked site or its sponsor, unless expressly stated by SL Advisors LLC. Any such information, products or sites have not necessarily been reviewed by SL Advisors LLC and are provided or maintained by third parties over whom SL Advisors LLC exercise no control. SL Advisors LLC expressly disclaim any responsibility for the content, the accuracy of the information, and/or quality of products or services provided by or advertised on these third-party sites.
All investment strategies have the potential for profit or loss. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be suitable or profitable for a client’s investment portfolio.
Past performance of the American Energy Independence Index is not indicative of future returns.