Recent news has dealt a drubbing to many hedge funds investors. The subprime mortgage fallout has awakened a great many sleeping giants whose excessive appetite for leverage seems to have caught them flatfooted when the housing market turned sour and easy credit dried up. In the wake of the crisis, many hedge funds are steeped in leveraged credit risk, facing crises of liquidity and viability that are leaving even some of the most powerful players impotent against collapse.  

A March 13, 2008 Times Online UK article by Suzy Jagger titled “Hedge funds on the brink as US Federal Reserve cash fails to ease crisis” reported that “the potential closure of six funds came as a leading private equity executive, who declined to be named, said that such funds were ‘snapping like twigs’, with one failing every day.”

So deep are the woes for some very large and big-name hedge funds that even the Fed’s $200 billion cash infusion couldn’t bring them back to moderate buoyancy. In fact, just one day after the Fed’s announcement, a whopping six well-known hedge funds with assets of $4 billion or more each lamented dim viability. For example, the crisis threatens the collapse of several Drake Management funds. According to Jagger’s article, Drake, which was founded by former Blackrock executives, just advised investors in its $3 billion Global Opportunities Fund that it was considering closing the fund. “The fund, which lost 25 percent last year, has already blocked investors from withdrawing their cash.” the article stated. 

Additionally, the federal bailout plan was not enough to salvage a once burgeoning investment fund affiliated with the high profile Carlyle Group. This powerful Washington-based buyout firm is widely known for its “gold-plated connections”; former IBM chief Louis Gerstner sits at the company’s helm, while former British Prime Minster John Major and former President George H.W. Bush were both employed by Carlyle, according to The Wall Street Journal’s March 14, 2007 article, “Carlyle Fund In Free Fall As Its Banks Get Nervous.” The article states that the fund that “had ballooned to $22.7 billion back in the era of easy borrowing all but collapsed as banks rushed to sell assets backing the mortgage fund. Shares of Carlyle Capital Corp., which trades in Europe, are down 97% for the year, closing yesterday at 35 cents.”

With the current cascade of faltering and failing hedge funds, a great many managers are no doubt struggling for just the right words to explain to investors the disastrous turn of events that renders their investments virtually worthless. We suggest they borrow a time-honored line from Theodor Seuss Geisel, “This mess is so big, and so deep and so tall. We can not pick it up, there is no way at all!” (The Cat in the Hat, by Dr. Seuss, aka Theodor Seuss Geisel)

Glyn Holt’s article “Hedge Funds: Who'll Take the Toxic Waste?” delivers a no-nonsense, take off the rose colored glasses view of hedge funds. He writes, “Anyone who has delved into the literature on efficient markets should smell a rat when thousands of hedge funds are being launched each year, all flamboyantly claiming they can earn returns massive enough to cover their typically 2% management fee, 0.4% "administrative fee" and 20% incentive fee, not to mention the enormous brokerage fees the funds rack up on their frenetic trading.”

Problems associated with hedge funds extend far beyond excessive fees. Indeed, fees are a huge stumbling block for hedge funds, to be sure. But, when coupling those excessive fees and performance bonuses with liquidity problems, a lack of transparency, leverage that can reach 10 to 1, and zero regulation from the SEC, hedge funds can impose great hazard on your ability to keep, let alone make money by investing in them.

The following five points succinctly express IFA’s Concerns with Hedge Funds:

1) The Risks of Hedge Funds

“The risks facing hedge funds are non-linear and more complex than those facing traditional asset classes…such risks are currently not widely appreciated or well-understood” – Andrew Lo (MIT)

Hedge funds often employ leverage, which as we all know, is a two-edged sword.  They also can concentrate their investments in risky securities, such as options which can easily lose 100% of their value. Conversely, they may take negative positions (shorts) in securities which can potentially have large appreciation, causing a large loss, which can be further magnified by leverage. Standard deviation does not adequately capture the risk of hedge funds, because a fund that is leveraged 10 to 1 goes out of business when it has a more than 10% decline in value. That does not happen in an index fund.

To cite some recent examples from the Wall Street Journal of 12/14/2007,  Red Kite Metals (a fund that was up 188% in 2006) has dropped about 50% year-to-date 11/30/2007. Two hedge funds run by Second Curve Capital are down about 70% over the same period due to souring investments in subprime lenders, after gaining 55% in 2006. In 2007, Peloton Partners ABS Hedge Fund racked up an 87% gain, in early 2008 they were forced to liquidate their once high-flying ABS fund after gambling big on a mortgage bond rebound that didn't materialize. In September 2007, a hedge fund expert from Mesirow Advanced Strategies in Chicago estimated that 50% of all hedge funds goes out of business every year.

Bottom line: If someone tells you that he has had a terrific gain (or knows someone who had one) in a certain hedge fund, it is highly probable that the hedge fund manager made some risky bets which could easily go against investors in the future.

2) The Returns of Hedge Funds

“We conclude that hedge funds are far riskier and provide much lower returns than is commonly supposed.” – Burton G. Malkiel & Atanu Saha, “Hedge Funds: Risk and Return”, Financial Analysts Journal, November/December 2005.

The article cited above showed that every major category of hedge fund (eleven categories) on average failed to provide a higher risk-adjusted return than the S&P 500 from 1995 to 2003. Only one category (emerging markets) provided a higher unadjusted return than the S&P 500.

Hedge fund statistics suffer from a severe survivorship bias problem. Failed funds go out of business and their returns go unreported. Likewise, poorly performing (but still existing) funds are under no obligation to report their returns to anybody.

One other often overlooked problem with hedge funds is that their assets are often of a highly illiquid nature, and the market values of those assets are somewhat opaque. A relevant example would be structured investment vehicles (SIV’s) resulting from securitization of subprime loans. Two hedge funds run by Bear Stearns that bought these types of vehicles collapsed in July of 2007, wiping out $1.6 billion of investor capital. Interestingly, $400 million of that capital belonged to Barclays, the world’s largest investment bank. If this entity cannot protect itself from the sharks of Wall Street, what chance does an individual investor have? Bottom line: If the values of a hedge fund’s assets are uncertain, then so are the returns reported by that fund. Buyer beware!

3) The Expenses of Hedge Funds

“Our research has shown that in at least 80% of cases the after-fee alpha for hedge funds is negative…I’m not saying they don’t have skill; I’m just saying they don’t  have enough skill to make up for two and twenty.” – John Cassidy, “Hedge Clipping”, New Yorker, 7/2/2007.

2% of assets and 20% of profits poses a high hurdle for an investor to receive a good experience in a hedge fund. If the fund (before expenses) receives an average market rate of return of 10%, the return to the investor (who took all of the risk) will be a mere 6.4%.

“On top of the enormous difficulties of identifying a group of genuinely skilled investment managers and overcoming the obstacles of extremely rich fee arrangements, investors confront a fundamental misalignment of interests created by the option-like payoff embedded in most hedge fund fee arrangements. Investors in hedge funds find generating risk-adjusted excess returns nearly an impossible task.” – David Swensen, Unconventional Success: A Fundamental Approach to Personal Investment.

On those rare instances where a manager has the market convinced that he can provide above average returns, his fees (or assets under management) will increase to the point where the expected return to investors is no higher than what the market will provide (and most likely will be significantly lower). A perfect illustration is Renaissance Technologies under the widely acclaimed James Simons. Based on his stellar past record, this fund now charges an astounding 5% management fee and 44% of profits.  In order for an investor to receive a 10% return, the fund itself must achieve a 23% return – A tall order to fill indeed. In fact, over the last 20 years Berkshire Hathaway has only earned about 20%/year, but also experienced a 23% standard deviation (risk) along the way.

4) The Myth of the Absolute Return Hedge Fund

“The term ‘absolute-return investing’ has no meaning. It misleads the listener into thinking it has substance that it does not have, and in our opinion, the term simply should not be used.” – M. Barton Waring and Laurence B. Siegel, “The Myth of the Absolute-Return Investor”, Financial Analysts Journal, March/April 2006.

Many hedge fund managers will claim that their funds are “hedged” against general market downturns. The funds most notorious for this type of claim are long/short funds. As William Sharpe so deftly asks, “If everybody was doing active management with hedge funds, and you put together all the hedge funds, what would you get? Treasury bills.” Investors must never forget that risk is the source of returns, and if they insist on reducing the risk to zero by hedging, they will have zero expected return.

The simple truth is that nobody can offer you an absolute return above T-Bills, without greater risk than T-Bills. While it is possible to generate a positive return above T-Bills for a period of time by selling out-of-the-money put options (or other derivative securities), such a strategy will eventually collapse. Therefore, even if a hedge fund can show a short term record of “absolute returns”, an investor should never think that these returns came without additional risk and that they will continue into the indefinite future. The distribution of past and expected future returns are approximately a bell shaped curve, with half of the returns being below the average and half being above the average.

5) What about a Fund of Funds?

Please note that all of the problems with ordinary hedge funds cited above are applicable to the funds of funds. The article by Malkiel and Saha cited above shows that the fund of funds category achieved a return that was 2.2% lower than the whole hedge fund universe (and 5.7% lower than the S&P 500). This shows that the managers of funds of funds have no special skill at picking other hedge fund managers. What a surprise!

Being a “qualified investor” does not entitle you to beat the market or to cheat risk. If you think otherwise, it is more than likely that someday you will pay a very high price to learn this lesson. Hedge funds will help you do just that.

The following table summarizes the key differences between index funds and hedge funds. We encourage every investor to make an informed decision when it comes to investing your hard-earned dollars.