Ritholtz On Hedge Funds

Barry Ritholtz who is CEO of FusionIQ, a quantitative research firm, the author of “Bailout Nation” and runs a finance blog, the Big Picture also publishes what I think is a weekly Sunday column in the Washington Post.  Here's an excerpt of an article he published on May 24, 2013 in the Post on hedge funds.  Hint:  It's not complementary to the Hedge Fund Industry.  {My highlights in Green.}

...."Despite all the media coverage, glitz and glam of hedge funds, they have not done well for their investors. They have high — some say excessively high — fees; their short- and long-term performance has been poor.......

.....Most hedge funds are “go anywhere” funds — they can own derivatives, mortgage-backed securities, credit-default swaps, structured products and illiquid assets. They also can use nearly unlimited leverage.  Gee, that sounds kinda hazardous. Why would anyone want to assume all of that risk? Originally, hedge funds earned their outsize compensation by, well, hedging their investments. This is a risk-mitigation strategy that can reduce the gains investors reap when markets are up but avoids much of the losses when markets are down.  That no longer seems to be the case with modern hedge funds. They have morphed into “absolute return” funds — more aggressive, greater leverage, more speculative, all in an attempt to generate returns that outperform their benchmarks. Not surprisingly, they have become riskier than the overall market.

Given these increased risks (and higher fees), how have hedge funds performed?

By most measures, not well. They have failed to keep up with major averages when markets were up — and they got mangled (like nearly everyone else) during the 2008-09 downturn. It turns out, most hedge funds are not very hedged.

The latest performance data (via the HFRX Global Hedge Fund Index) reveal that hedge funds haven’t fared well at all: They returned a mere 3.5% in 2012, while the S&P 500-stock index gained 16 percent. Over the past five years, and the hedge fund index lost 13.6 percent, while the indices added 8.6 percent. That’s as of the end of 2012; it has only gotten worse in 2013. Most hedge funds have fallen even further behind their benchmarks this year, gaining 5.4 percent vs. the market’s rally of 15.4 percent. As a source of comparison, the average mutual fund is up 14.8 percent.

Which brings us to fees. Most hedge funds charge an industry standard “2 and 20.” This is a 2 percent annual management fee against the original investment, plus 20 percent of the investment profits. Compare this with annual mutual fund fees, which average about 1.44 percent. Fees for an index ETF are typically under 0.25 percent.

Those outsize hedge fund fees are an enormous drag on performance. But they do create wealth — for the managers.....“Two and twenty” as the industry calls it, is why even middling hedge fund managers can become billionaires. According to Simon Lack, author of “The Hedge Fund Mirage,” this fee arrangement is effectively a wealth transference mechanism, moving dollars from investors to managers. As he puts it: “While the hedge fund industry has generated fabulous wealth and created many fortunes, it has largely done so for itself.”

Lack is no ordinary critic — he spent his career at JPMorgan Chase, where he allocated more than $1 billion to emerging hedge fund managers. Some of the statistics he amassed in the process are nothing short of astonishing:

●From 1998 to 2010, hedge fund managers earned $379 billion in fees. The investors of their funds earned only $70 billion in investing gains.

●Managers kept 84 percent of investment profits, while investors netted only 16 percent.

●As many as one-third of hedge funds are funded through feeder funds and/or fund of funds, which tack on yet another layer of fees. This brings the industry fee total to $440 billion — that’s 98 percent of all the investing gains, leaving the people whose capital is at risk with only 2 percent, or $9 billion.

What other concerns should investors have? Hedge funds are not especially liquid. Many are “gated” — meaning there are only small windows when you can withdraw your money. They typically have a high minimum investment and often require investors keep their money in the fund for at least one year....

....The Lebron James of hedge fund managers are few and far between. This is the crux of the issue with hedge funds. A small percentage have significantly outperformed the markets; an even smaller percentage have done so after fees are taken into account. While we all know which ones have outperformed over the past few decades, no one has even the slightest clue which ones will outperform over the next one. It is akin to picking out from the ranks of high school sophomores who will be the next NBA superstar. Best of luck with that.

Every fund in the world warns that past performance is no guarantee of future results. It is too bad that investors refuse to believe it.

Link:  Ritholtz:  I Hedge Fund for You and Me?  The Best Move is to Take a Pass.