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2012-01-12 07:08:51
A devastating analysis of hedge-fund returns
Jan 7th 2012 | from the print edition
HEDGE-fund managers are the smartest investors around. With keen eyes and sharp
brains, they spot and exploit inefficiencies in the markets. Or at least that
is what the industry tells its clients.
There is no doubt that hedge-fund managers have been good at making money for
themselves. Many of America s recently minted billionaires grew rich from hedge
clippings. But as a new book* by Simon Lack, who spent many years studying
hedge funds at JPMorgan, points out, it is hard to think of any clients that
have become rich by investing in hedge funds (whereas Warren Buffett has made
millionaires of many of his original investors). Indeed, since 1998, the
effective return to hedge-fund clients has only been 2.1% a year, half the
return they could have achieved by investing in boring old Treasury bills.
How can that be, when traditional performance measures for the industry show
average returns of 7% or so? The problem is a familiar one in fund management
and is the equivalent of the winner s curse that occurs with auctions (the
successful bidder is doomed to overpay). Take a whole bunch of fund managers
and give them an equal amount of money to invest. The managers that perform
best initially will tend to attract more investors, and so will gradually
become bigger than the moderate or poor performers (who will eventually go out
of business).
But the manager will not perform well indefinitely. By the time a bad year
occurs, the manager will be running a much larger fund. In cash terms, the loss
on the expanded fund may easily outweigh the gains made when the fund was
smaller. The return of the average investor will be lower than the average
return of the fund.
What is true for individual funds also turns out to be true for the industry as
a whole. Between 1998 and 2003 the average hedge fund earned positive returns
every year, ranging from 5% in 2002 to 27% in 1999. Back then, however, the
industry was quite small: overall assets only passed $200 billion in 2000.
That strong performance attracted the attention of pension funds, charities and
university endowments at a time when their portfolios had been clobbered by the
bursting of the dotcom bubble. They duly piled into alternative assets like
hedge funds and private equity. By early 2008 the hedge-fund industry had
around $2 trillion under management.
But that year turned out to be the annus horribilis for the hedge-fund sector.
The average performance was a loss of 23%. In cash terms the loss for that
single year was more than double the industry s total assets under management
in 2000, when it was still doing well. Mr Lack reckons that the industry may
have lost enough money in 2008 to cancel out all the profits it made in the
previous ten years.
At this point, hedge-fund managers might cry foul. The losses suffered in 2008
make a huge impact on the way Mr Lack calculates his figures. If you use the
same methodology on stockmarkets, hedge funds outperformed the S&P 500 between
2001 and the end of 2010.
But private-equity managers are judged on a similar basis (the internal rate of
return) to Mr Lack s calculations. And his numbers probably flatter the
hedge-fund industry. Indices of hedge-fund returns overstate the numbers
because of factors such as survivor bias (poor performers stop reporting
their numbers) and backfill bias (only successful newcomers start to report).
These effects could add 3-5 percentage points a year to average returns. Many
investors invest in the sector through funds of funds, which charge an
additional layer of fees.
Even if you allow for the rebound in markets (and hedge-fund returns) in 2009
and 2010, investors have still got the short end of the stick. They have yet to
recover the losses suffered in 2008. But hedge-fund managers took home almost
$100 billion in fees between 2008 and 2010 (and an aggregate haul of $379
billion between 1998 and 2010).
Mr Lack s book suggests the blind faith displayed by many institutional
investors in hedge funds needs to be reconsidered. Individual managers may be
brilliant but it is hard to spot them in advance. John Paulson was not
particularly well-regarded before he made a fortune betting against subprime
bonds and his performance has slumped since. Investing in hedge funds will
enable some lucky managers to enjoy an early retirement on their yachts. It
will not enable pension funds to eliminate their deficits.
True , published by John Wiley & Sons, January 2012