The recent release of Institutional Investor Alpha’s hedge-fund survey has everyone asking how the fund managers continue to make so much money. Academics and journalists alike point out that hedge funds, as a class, haven’t delivered above-market after-fee returns for quite some time. Hedge funds, of course, get paid whether the market goes up or down, so the real question is why hedge funds continue to receive large inflows of capital from pension funds and other investors. The New Yorker magazine’s John Cassidy has a good roundup of the most prominent theories. He includes some good links to research on the question of whether hedge funds deliver superior risk-adjusted returns, or offer significant diversification potential.
But the real question is: Why would people expect hedge funds to deliver superior returns in the first place?
People often seem to treat the term “hedge fund” as if it’s a shorthand for “money manager of unusual skill.” At the Skybridge Alternatives Conference (SALT) last year, host Anthony Scaramucci told attendees that “Mutual funds are the propeller planes…while hedge funds are the fighter jets.” And of course we’ve all heard of those famous world-beating billionaire hedge-fund managers like John Paulson, Ken Griffin or Cliff Asness.
But is there any fundamental characteristic common to all or most hedge funds that makes them “fighter jets”? “Hedge fund,” after all, is just a legal category. There are regulations governing what kind of assets a fund is allowed to trade, and what kinds of clients the fund can service. Hedge funds are only allowed to sell to certain types of investors -- rich people, large institutions and those who qualify as so-called sophisticated investors. In exchange for this limitation on who can invest in them, they are exempt from most restrictions on what kinds of assets they can trade and how much leverage they can take on.
Theoretically, this exemption should mean that hedge funds offer the potential for diversification. Since they can invest in things other funds can’t, buying into hedge funds can theoretically give an investor access to a wider universe of assets.
But beyond that, there is little reason to believe that hedge funds as a group offer anything special. After all, any Tom, Dick or Harry can start a hedge fund. That’s right -- all you need is a business license. You can start a hedge fund without ever having managed a dime of money in your life. That’s called “free entry.” In economics, free entry means that average profits in an industry (net of opportunity cost) should be competed away to zero. Why should hedge funds be any different?
In other words, if a pension-fund manager or rich investor hurls his money at a fund just because it's called a “hedge fund,” he isn't making a sophisticated, market-beating choice; he is paying through the nose to take a lot of risk and get a bit of diversification. Thus, it’s no surprise that during the past couple of decades, even as money has continued to flow into hedge funds, their return hasn't impressed. Free entry has competed away the ability of the hedge-fund class to beat the market.
So how did hedge funds get such a good reputation? Well, it’s possible that their eye-catching early performance was a kind of loss leader. In the beginning, investors probably shied away from this scary new asset class, so higher after-fee returns were necessary to convince them that hedge funds were for real. After the word got out about the high returns and hedge funds became known as “fighter jets,” hedge funds were free to charge higher fees and a huge flood of scrubs entered the profession. The net result was that after-fee returns to the hedge fund class as a whole collapsed.
Now, this doesn’t mean there aren’t hedge-fund managers who can beat the market. As in the venture-capital industry, there seem to be a few superstars who really can deliver superb performance, year in and year out. You already know many of their names. The catch is, these superstars are unlikely to need your money. By the time we discover them, they already have a lot of capital, and taking on more would make it hard for them to keep generating market-beating returns. In other words, the only way to find a hedge-fund who can reliably beat the market for you is to pick one who’s not yet a star, but is destined to become one.
So here’s the real question: Do you, as a pension-fund manager, or rich individual investor, think that you have an above-average ability to pick out the non-superstar hedge funds that will outperform in the future? And if so, why? Also, is your superior fund-picking ability worth the average hedge-fund fee?
If you decide the answer is “no,” then you should consider investing in an index that tracks average hedge-fund returns (like the HFRX Global Hedge Fund Index), in order to get that bit of diversification without paying the big hedge-fund fees.I like this comment until that last paragraph. I wouldn't touch the HFRX Global Hedge Fund Index for the same reason that I wouldn't touch any private equity index. If you're not invested in top decile funds, it's not worth investing in any hedge fund or private equity index. You are better off investing in S&P 500 over the long-run.
I've already covered some of my thoughts on the great hedge fund mystery and ended that comment by stating:
...any guy who would surgically implant fat cells in his penis needs to get his head examined. And any pension fund that needs to be invested in the "biggest" hedge funds no matter what the fees and performance needs a reality check. When it comes to penises and hedge funds, bigger isn't always better!I wasn't kidding around. People are stupid. In fact, the older I get, the more cynical I've become on the collective stupidity of the masses. Millions of people are led into believing all sorts of garbage and their insecurities translate into big dollars for many industries, including the alternatives industry.
The same thing goes on in the pension fund world. "Oh, Joe just wrote a $200 million ticket to hedge fund X and a $500 million ticket to private equity fund Y, he must have a big penis but I will show him!" Unfortunately, the only thing you're showing Joe is how much shit for brains you've both got!
Go back to read my comments on Ron Mock's thoughts on hedge funds here and here. I don't want to make Ron sound like the guru of hedge fund investing. He's not, he's made plenty of mistakes and got clobbered in 2008 investing in all sorts of illiquid and funky hedge funds which I wouldn't have touched with a ten foot pole.
But Ron knows all about alpha and he learned from his mistakes, including mistakes from managing his own sizable fixed income arbitrage fund which blew up because of a rogue trader. He also knows how important it is to make sure alignment of interests are there. Teachers has a hedge fund bogey of T-bills+5% and they invest mostly in market neutral strategies. When it comes to assets under management, their sweet spot for hedge funds managing between $1 and $3 billion, big but not too big that they have become large and lazy asset gatherers collecting that 2% management fee, focusing more on marketing than performance. Also, after the 2008 debacle, Teachers was forced to tighten up liquidity risk, so they moved most of their hedge funds on to a managed account platform (managed by Innocap) but still invest in illiquid strategies (which are not conducive to managed account platforms!).
Back to the comment above. The only people getting rich on hedge funds are overpaid hedge fund gurus, brokers recommending the new asset allocation tipping point (so they can generate more fees), and useless investment consultants who are now competing with funds of funds, investing in hedge funds. The name of the game is fees and asset gathering.
But the alternatives gig is up. When you see CalPERS chopping its allocation to hedge funds, you know something is up. Also, pension funds are focusing a lot more on fees and I think the era of fee compression has just begun.
One little mistake I made in some recent comments was mixing up the hurdle rate with the high water mark. I challenged the Bridgewaters and Blackstones of this world to do away with management fees completely, share the pain of deflation, and set a hurdle rate of T-bills + 5% before they charge performance fees (PE funds all use a hurdle before they charge performance fees). Of course, no mega fund will ever accept my challenge and why should they? Dumb public pension funds are more than happy to feed these alternative powerhouses and keep paying them outrageous fees.
This is one area which Thomas Piketty needs to examine. The ability of the financial elite to bamboozle pensions into investing in high fee funds has led to enormous wealth. But while the media loves glorifying hedge fund "gods", I remain very skeptical on pensions praying for an alternatives miracle. Also, as I wrote in the hedge fund curse, even the big boys lose money, and lots of it, so don't blindly follow their 13-F moves.
Finally, remember the wise words of Leo de Bever, who is stepping down from AIMCo. Leo once told me "if I can find the next Warren Buffett, I'd invest with him, but I can't, so I'd rather bring assets internally and cut the fees I pay external managers." Smart man which is why you won't see him get all giddy on hedge funds.
Below, Anthony Scaramucci of Skybridge Capital on the sovereign debt market and other major themes of the conference in Las Vegas. Who would have thought Greek bonds would have been the best asset class last year? Dan Loeb and yours truly, that's who!