Fingers Crossed Behind Back

MANY people would jump at the chance to invest in hedge funds, which have mainly been available to only the very wealthy. But a new study finds that the funds’ high fees make it unlikely that investors will improve their long-term performance by putting money into hedge funds.

The study, “Portfolio Efficiency With Performance Fees,” was written by Mark Kritzman, president and chief executive of Windham Capital Management, a money management firm in Boston. Mr. Kritzman also teaches a graduate course in financial engineering at the Sloan School of Management at the Massachusetts Institute of Technology, and his article grew out of work begun by a few of his graduate students there. The article appeared in the Feb. 1 issue of Economics and Portfolio Strategy, a newsletter for institutional investors, published by Peter L. Bernstein.

Hedge funds are largely unregulated and therefore are free of the restrictions that keep most mutual funds from pursuing untraditional investment strategies like selling short and investing in complex derivatives. As a result, hedge fund managers argue that they can produce impressive returns regardless of whether the stock and bond markets are going up or down or are trendless — a feature that would be particularly welcome in turbulent weeks like the last one. But because hedge funds typically become subject to greater regulation once they have more than a small number of investors, in most cases they are limited to a few very wealthy individuals.

Mr. Kritzman’s article focuses on the effect of the fees that hedge funds charge. In addition to a percentage of assets under management, hedge funds typically also charge a percentage of their profits. The standard fee arrangement in the industry, known as “2 and 20,” is to charge 2 percent of assets under management and 20 percent of profits above a predetermined benchmark, like the London Interbank Offering Rate, or Libor. Mr. Kritzman found that the combined impact of such fees is so high as to greatly reduce the attractiveness of hedge funds.

Consider a hypothetical portfolio that Mr. Kritzman put together. He divided it equally among 10 imaginary hedge funds, each of which he assumed would earn a long-term annualized return of seven percentage points above Libor, before fees — an assumption that he says is realistic. Mr. Kritzman calculates that the 2-and-20 arrangement would cost this portfolio 3.8 percentage points a year. Given Libor’s current level — about 5.4 percent — this implies that the hedge-fund basket would have an after-fees return of 8.6 percent, annualized.

In an interview, Mr. Kritzman said the fees’ effect on the portfolio was so sizable because of the “asymmetry penalty” resulting from the 20 percent cut of profits that the hedge funds earn. The funds do not share in investor losses — but they reap a large share of the profits.

To illustrate how these fees can add up, Mr. Kritzman conducted another experiment. He tried to determine how much a rational investor should allocate to this hypothetical portfolio of 10 hedge funds, when also given the opportunity to invest in a stock index fund and a bond index fund.

Calculating the optimal allocation required Mr. Kritzman to make a number of assumptions about the two index funds, like how much they would earn, how volatile their returns would be and how their returns would correlate with each other and with those of his hypothetical group of hedge funds. Once those assumptions were made, it was a matter of simple math to calculate which allocation produced the greatest long-term return relative to the amount of risk incurred along the way.

Mr. Kritzman found that, given these assumptions, the investor should allocate nothing to the basket of hedge funds and everything to the two index funds.

It might appear as though Mr. Kritzman assumed too low a return for his basket of hedge funds. Data from Hedge Fund Research, a company in Chicago that tracks the industry, shows the average hedge fund to have gained 10.6 percent annualized, after fees, over the 10 years ended in December, in contrast to the 8.6 percent, annualized, that is implied by Mr. Kritzman’s assumption. But he said his assumed return was reasonable because of a tendency of poor-performing hedge funds not to report data to firms that monitor the industry.

WHAT role did high fees play in his finding that an investor should allocate nothing to hedge funds? Mr. Kritzman recalculated the optimal allocation, assuming that hedge funds earned only a flat 2 percent of assets under management. (That fee would still be roughly a half percentage point more than that of the average actively managed stock mutual fund.) Using that assumption, he calculated that the optimal allocation would be much different: 74 percent to the hedge fund basket and 26 percent to the index funds.

What about so-called funds of hedge funds, which have lower minimums and are therefore available to less-affluent investors? Mr. Kritzman says he finds it difficult to justify any allocation to funds of hedge funds, because they earn fees above and beyond those earned by the hedge funds in which they invest, typically 1 percent of funds under management and 10 percent of profits above a benchmark.

The bottom line, Mr. Kritzman said, is this: “Because of fees, the optimal allocation to a group of

hedge funds is a lot lower than you might think it should be.”

Mark Hulbert is editor of The Hulbert Financial Digest, a service of MarketWatch. E-mail: [email protected]