Fingers Crossed Behind Back

Bloomberg BusinessWeek Busts the Hedge Fund Myth

Fingers Crossed Behind Back

While the cover of this week's issue of Bloomberg BusinessWeek is definitely more risqué than what we usually see from this publication, the message of Sheelah Kolhatkar's article, Hedge Funds Are for Suckers, is inarguable. Although there is no earth-shattering new information, Kolhatkar does an excellent job summarizing both the general problems faced by the $2.3 trillion hedge fund industry such as poor returns compared to basic index funds as well as the issues confronted by specific hedge funds such as the on-going SEC/FBI investigation of SAC Capital Advisors for insider trading, which may eventually lead to an indictment of its billionaire founder, Steven Cohen.

As noted by Kolhatkar, the essential problem is that hedge funds have become a victim of their own popularity with qualified investors: "Hedge funds may have gotten too big for their yachts, for their market, and for their own possibilities for success…Most of the advantages their investors once had—from better information to far fewer people trying to do what they do—have evaporated." In other words, it's not just that would-be hedge fund investors will be late to the party, but they will arrive after the punchbowl has been put into the dishwasher and the band has packed up its musical instruments.

A poignant example of late arrival to the party is the group of people who poured money into John Paulson's fund. You may recall that Paulson was one of the few people to make a killing during the mortgage meltdown of 2007-8. His exploits are recounted in The Greatest Trade Ever. Unfortunately, his current investors probably feel like the greatest dunces ever, as Kolhatkar notes that Paulson's Advantage Plus Fund is up 3.4% this year, after losing 19% in 2012 and 51% in 2011. Paulson is certainly not alone in his sorrows. The world's largest hedge fund company, Bridgewater Associates, has seen its All Weather Fund lose 8% year-to-date compared with a 10.3% rise in the S&P 500. Of course, investors who believe that they have found a fund that will do well regardless of what happens in the market should expect to be disappointed, as such an animal can be considered the unicorn of the financial world, existing only in fairy tales.

Kolhatkar correctly questions the sustainability of the standard hedge fund fee structure of 2% of assets and 20% of profits. For example, a $3 billion fund that posts a 6% return would generate $60 million in asset-based fees plus $36 million in profit-based fees. Now we start to understand why the yachts are so damn big. We also start to understand why the large hedge fund managers appear to wield a large amount of influence in Washington, and as this article from BusinessInsider shows, they are happy to pump dollars into the coffers of both Republicans and Democrats. This article states that in the two decades from 1990 to 2010, hedge fund managers and their staff contributed about $51 million to the two political parties. This does not include many more millions of contributions to political action committees. So what have the lords of finance reaped from the political seeds sown? Perhaps the newly found ability to advertise to the general public, although they will still only be able to accept funds from qualified investors. Twitter has treated us to some potential advertising slogans such as "Creating alpha since, well, mostly never (Berry Ritholtz) and "Leave the Frontrunning to Us!" (@IvanTheK).

One excellent follow-up piece to Kolhatkar's article was penned by Neil Irwin of the Washington Post. He beautifully illustrates just how difficult (if not impossible) it is for investors to distinguish between luck and skill. Essentially, a hedge fund manager can place a bet that has a 10% return on the plus side and a complete loss of principal on the minus side. An example would be selling out-of-the-money put options which would be profitable as long as the market does not endure a large drop. If the bet goes well for a few consecutive years, and odds are that it should, the manager looks like a hero and is invited to appear on CNBC like this scoundrel. The essential problem is that investors have no reliable way of distinguishing if high returns came from luck or skill, or better still, financial fraud such as Ponzi schemes or insider trading. Nevertheless, here is a really good hint from Josh Brown of the Reformed Broker Blog: If a hedge fund manager possesses true skill and can consistently generate alpha, then he will neither want nor need you to be his investor.

While it may not have been polite to resort to such a graphic cover, Bloomberg BusinessWeek has done a service for current and potential hedge fund investors who might have been sitting on the fence. While we have been saying this same message for many years now, we are always happy to hear prominent voices added to our own.