In a December article entitled “Going Nowhere Fast,” The Economist reported that the S&P 500 has outperformed its hedge-fund rivals for 10 straight years, with the exception of 2008, when both suffered grievously.
“A simple-minded investment portfolio — 60 percent of it in equities and the rest in sovereign (world government) bonds — has delivered returns of more than 90 percent over the past decade, compared with a meager 17 percent after fees for hedge funds,” the magazine reported. “As a group, the supposed sorcerers of the financial world have returned less than inflation. Gallingly, the profits passed on to their investors are almost certainly lower than the fees creamed off by the managers themselves.”
Hedge Fund Research, a well-regarded provider of alternative investment-performance data, shows the average hedge fund returned 3.51 percent for 2012. At the same time, Standard & Poor’s 500 index funds returned 12.3 percent.
While these numbers are sobering, they do not provide an open-and-closed case on the merits of hedge funds. Specifically, because almost all hedge funds have a combination of long and short positions, their returns are dampened in bull markets.
Hedge funds are aggressively managed portfolios of investments. They can employ leverage; go long or short; and purchase derivative positions. Their goal is to achieve high returns either on an absolute basis or over a specified benchmark. Hedge funds can embrace strategies far outside of the domestic equity market. They can focus on junk bonds, commodities, currencies, and developing countries.
Instead of focusing on absolute numbers, investors should judge hedge funds’ performance relative to the benchmark of their investing criteria.
The hedge fund industry does have some market-beating superstars. According to Hedge Fund Research, the top 10 percent of managers has generated returns of more than 30 percent in 2012. On the other hand, most of its 8,000 participants have posted mediocre results, and sometimes even superstars stumble. In 2007 and 2008, John Paulson made billions of dollars for his investors. He then crashed to earth.
On Jan. 6, 2012, The New York Times reported “His Advantage Plus fund lost 52.5 percent, the unleveraged Advantage fund fell 36 percent and his so-called Recovery fund, which was betting on the resurgence of the United States economy, dropped 28 percent.”
In the 1980s, George Soros, Michael Steinhardt and Julian Robertson made hedge funds famous because of their outsized profits. Their investor base, wealthy individuals, accepted the high volatility of returns as the cost of reaching for the stars. During my tenure at Steinhardt Management, 1989-1995, Mike Steinhardt encouraged us to bet big.
But now, because of a change of its investor base, the industry focuses on offering low volatility. Currently, two-thirds of the industry’s assets are drawn from pension funds, endowments and other institutional investors. These professional investors are much more risk-averse than wealthy individuals.
Simon Lack embodies the change in attitude toward the hedge fund industry. Lack was an advocate, serving on JP Morgan’s investment committee, allocating more than $1 billion to hedge fund managers. Now, he has become a vocal critic of hedge funds. Lack articulated the problems in his “book, The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to Be True.”
Lack argued that Hedge Funds are a victim of their success. Hedge funds now manage $2.2 trillion in assets, up fourfold since 2000.
“Returns were good when the industry was small. As assets flowed in, returns fell. Because individual trades can absorb only so much cash, the effect of all that new money is to push funds to take second-rate bets that would have been considered marginal in the past.”
Originally published in the Sarasota Herald-Tribune
