The great hedge fund anomaly

Financial Review

PUBLISHED: 11 Feb 2012

Anna Bernasek, New York

Is there a bubble in the hedge fund industry? For some time now there’s been talk about an impending shake-up in hedge funds. Growth was expected to drive the industry’s performance down toward the average, with more competition resulting in lower fees.

In the aftermath of the 2008 financial crisis, that shake-up seemed imminent. The industry’s poor performance, coupled with shocking scandals like Bernie Madoff’s fraud, shook some observers’ faith in the sector. But apparently little has changed.

True, some high-profile funds have closed their doors and some big ones have become smaller. But on the whole, the industry is booming. Fees remain as high as ever and money is pouring in.

What makes it all the more puzzling is that hedge fund performance, especially of late, hasn’t lived up to the industry’s promise of outsized returns. In fact, looking at industry returns, it’s hard to fathom why investors keep investing.

Take last year for instance. On average, hedge funds lost 5 per cent, according to Hedge Fund Research. That’s not great compared with a popular reference, the S&P 500 stock index, which was flat for the year. Or the Dow Jones Industrial Average, which gained 5 per cent.

And last year’s dismal performance of the hedge fund industry is not an isolated event. For two years hedge funds have underperformed the broader stockmarket. What’s more, analysis suggests that investments in hedge funds over the long term have underperformed, not only investments in major stockmarket indices but bond market indices too.

A recent book, The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good To Be True, by Simon Lack, raises serious concerns. At the centre of Lack’s book is a shocking conclusion: “If all the money ever invested in hedge funds had been put in Treasury bills instead, the results would have been twice as good.”

Looking at performance of the industry since 1998, Lack figures that the vast majority of gains have gone to the hedge fund managers as opposed to their investors. In fact, Lack plausibly suggests that in real terms, investors may have lost money in hedge funds over the period while managers raked in stupendous sums.

Proponents of hedge funds will say that the funds, on average, have lost money in just three years since the industry was formed. But their numbers are shaky. The hedge fund indices are calculated based on voluntary reporting. If a hedge fund has a bad year and it keeps quiet, those numbers don’t go in the index. Funds can selectively report good numbers in good years, driving up the indices.

Without detailed disclosure it’s hard to be confident of the quality even of the reported numbers. It’s not beyond the imagination to suppose that accounting games are played behind the scenes.

And, of course, the secrecy of the industry provides an ideal environment for occasional outright frauds. Hedge fund managers like Bernie Madoff and Raj Rajaratnam have become household names because of their crimes, yet there are many more managers still under investigation.

Philip Falcone, the manager of Harbinger Capital Partners, is among the latest to be investigated by the Securities and Exchange Commission for a $113 million loan he took out of his funds to pay his personal taxes.

Despite fraud and poor performances, hedge funds seem to be more popular with investors than ever. The total dollar amount invested in hedge funds hit a record last year of more than $2 trillion.

If you pick the right fund you can win big. While the average one has underperformed the broader market, some have spectacularly outperformed everyone.

Look at Bridgewater Associates for instance, the world’s biggest hedge fund with almost $120 billion under management. Bridgewater bucked the downward trend in hedge fund performance last year by making a 23 per cent gain.

The curious thing about the growing popularity of hedge funds is that demand seems to be coming from the very institutions that can’t afford to lose big – private and public pension funds.

In today’s low interest rate and relatively flat stockmarket, pension funds are having great difficulty meeting their 8 per cent target return on investments. As a result, many are taking a bet on hedge funds in the hope that they produce additional returns. Some estimates have a typical pension fund now holding 20 per cent of its portfolio in so-called alternative investments including hedge funds, private equity and real estate.

There’s nothing wrong with trying to make money in hedge funds. But the typical fee structure – the so-called “2 and 20”, where managers take 2 per cent of assets and then another 20 per cent of any profit – is so rich it may turn out to be impossible to justify. All those pension fund managers piling into hedge funds could wind up with egg on their faces.