David Peartree, The Daily Record Newswire
Are investment returns greener on the hedge fund side of the fence?
No, they are not. Hedge funds and their wicked younger cousins, mutual funds imitating hedge fund strategies, have little to offer most investors. But sometimes it’s instructive for investors to look at things on the other side of the fence to remind themselves that more exotic isn’t necessarily better and may, in fact, be far worse.
From a small start in the 1990s, hedge funds have grown to manage an estimated $2.75 trillion of assets. Some high profile success stories in the early years helped fuel their rapid growth. Hedge fund managers John Paulson and George Soros each made large bets that propelled them to fame and fortune. Soros bet against the English pound in 1992 and Paulson bet against subprime mortgages in 2007. Starting with several hundred funds in the early 1990s, the industry ballooned to several thousand funds two decades later.
Hedge funds are relatively unregulated investment pools typically run by limited partnerships or offshore corporations. The original aim of hedge funds was to hedge market returns by producing returns that were not correlated with market returns. Usually this meant being down by less when markets were down, but it also meant being up by less when markets were rising.
These days, however, hedge funds pursue one or more complicated, often quantitative, strategies. They are sometimes marketed as all-weather performers, strategies that can do well in any market conditions. Strategies include: long-short equity, equity market neutral, convertible arbitrage, fixed-income arbitrage, global macro, emerging markets, event driven hedging, dedicated short and managed futures.
Hedge fund managers are widely assumed to be the best and the brightest among investment managers and, perhaps, some of them are. But apart from the outsized successes of a relative few the collective performance of the hedge fund industry has been poor.
From 2004 through 2013 the HFRX Global Hedge Fund Index, a composite benchmark of the above strategies, underperformed all classes of U.S. and international stocks. In fairness, most hedge funds are not pure stock strategies, so a comparison with straight stocks indexes is not quite apples-to-apples. However, the index also underperformed a very conventional portfolio of 60 percent stocks and 40 percent bonds. Simon Lack, the author of “The Hedge Fund Mirage,” published in 2012, reported that a 60/40 portfolio has beaten the average hedge fund every year since 2002.
The classic 60/40 allocation is a very good proxy for a balanced portfolio and represents a plain vanilla way to hedge stock risk by holding bonds. The inability of the average hedge fund to do better is telling.
Despite their mystique, hedge fund managers present some of the same challenges as other active investment managers: the number who deliver superior performance is quite low, there is little evidence of persistence among superior performers, and there is no reliable method for identifying the superior managers in advance.
Beyond those already well-documented problems, hedge funds present their own unique set of challenges. Start with their lack of transparency. Timely information on what they own and what they’ve traded is very difficult if not impossible to access.
Hedge funds are typically very expensive. Management fees of 2 percent and performance fees taking 20 percent of gains are quite common. Due to high frequency trading, they can also be highly tax-inefficient.
Hedge funds tend to be illiquid. They may be subject to redemption restrictions and lock-up periods. Hedge funds often use leverage, always a potential source of risk.
Hedge funds have a high closure rate. A lot of them just don’t last very long. One study documented a 63 percent closure rate from 1995-2009. And finally, performance reporting is largely voluntary.
The larger question for investor is what exactly are they trying to achieve? If it’s market-beating performance, few hedge funds outperform the market straight up. If it’s hedging against market downturns, a simple 60/40 portfolio does that more efficiently than most hedge funds.
If the grass is greener for hedge fund investors, it is only for a very few. Successful hedge fund investing represents at best a small patch of green in a larger swath of desolation caused by high fees and black box strategies.
Earlier this month the California Public Employees’ Retirement System, known as CALPERS, announced that it would be dropping all of its hedge fund exposure. CALPERS is the largest pension plan in the U.S. and one of the largest in the world. It cited cost and complexity as two reasons for getting out.
For most investors, the grass is green enough on their side of the fence. Portfolios built around traditional asset classes – especially stocks, bonds and real estate – and using strategic rather than tactical investment strategies are more than good enough to meet their needs.
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David Peartree, JD, CFP® is the principal of Worth Considering, Inc., a registered investment advisor offering fee-only investment and financial advice to individuals and families. Offices are located at 160 Linden Oaks, Rochester, NY 14625, david@worthconsidering.com.
