Fingers Crossed Behind Back

Interested in Hedge Funds and Private Equity? Read This First

Fingers Crossed Behind Back

If you are contemplating a potential investment or you are already invested in a hedge fund, IFA urges you to read the rest of this article. If you are under the impression that you are obtaining the services of a "great manager" who is only available to "qualified investors" like yourself, you would do well to consider the following points:

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 invest in securities (such as options) which can easily lose 100% of their value. Conversely, they may take negative positions in securities which can potentially have large appreciation, causing a large loss, which can be magnified by leverage. Standard deviation does not adequately capture the risk of hedge funds.

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.

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 fund returns is that the assets held 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.

4) The Illiquidity of Hedge Funds

  • Many hedge funds make it very difficult for investors to withdraw their money.

  • A particularly egregious example is Eric Mindich's $12 billion Eton Park Capital Management which requires investors to stay for a minimum of 27 months and if they decide to pull out after the 27 months, they can only redeem one-third of their account value in any given year. The only way to get around these terms is to pay a 6% early-exit penalty.

    http://finance.fortune.cnn.com/2012/01/17/eric-mindich-eton-park/

5) 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 points out, if all active management were done with long/short funds and all these funds were combined, all you would be left with are T-Bills. Investors must never forget that risk is the source of returns, and if they insist on hedging themselves against risk, they will have zero expected return (beyond T-Bills).

The simple truth is that nobody can offer you an absolute return above T-Bills without risk. While it is possible to generate a positive return above T-Bills (with zero standard deviation!) 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 record of "absolute returns", an investor should never think that these returns came without risk or that they will continue into the indefinite future.

6) What about a Fund of Funds?

"Diversification is only required when investors do not understand what they are doing." – Warren Buffett

DISCLAIMER: IFA firmly believes that diversification within and across asset classes is the investor's friend because it reduces standard deviation without reducing expected return. Also, Mr. Buffett himself has since become a strong proponent of indexing.

The above quote definitely applies to funds of hedge funds because the overwhelming majority of hedge fund investors are simply incapable of explaining what the fund is doing with their money. With a fund of funds, they have many different funds all doing different things that they still don't understand, but they can sleep better at night. Please note that all of the problems with ordinary hedge funds cited above are applicable to the funds of funds. An additional problem is that each of the funds is charging the two and twenty (or perhaps more), and on top of that, the hapless investor is paying an additional fee (perhaps another two and twenty?) to the fund 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!

7) The Checkered Record of Hedge Fund Managers

Since hedge funds are not regulated to the same extent as mutual funds, there is a far higher potential for them to be used as vehicles for financial fraud. Below is a partial list of hedge fund managers who landed on the wrong side of the law, while many of their investors got taken to the cleaners.

The Hedge Fund Manager Hall of Shame

The Hedge Fund Manager Hall of Shame

Additional Articles About Hedge Funds

January 19, 2012 - Hedge of Darkness

January 19, 2012 - Problems with Private Equity Performance

Hedge Fund Study Chart

 

October 19, 2009 - Hedge Fund Chief Is Charged With Fraud --- 14 More Charged with Insider Trading in Galleon Hedge Fund -- You were told way back in 2004.

July 9, 2009 - John Meriwether to shut hedge fund

(Reuters) - John Meriwether's hedge fund firm JWM Partners LLC plans to close his current hedge fund, which lost 44 percent from September 2007 to February 2009, Bloomberg reported, citing a person familiar with the matter. JWM is closing its main Relative Value Opportunity II fund which was started after Meriwether's previous hedge fund, Long-Term Capital Management, collapsed and had to accept a $3.6 billion bailout by U.S. banks in 1998 after it ran aground due to leveraged trading strategies. The Relative Value Opportunity II fund returned an average of 1.46 percent a year since it began trading in Nov 1999, the report said, while the Credit Suisse/Tremont Hedge Fixed-Income Arbitrage Index gained 2.4 percent a year in the same period. JWM could not be immediately reached for comment by Reuters. JWM Partners, based in Greenwich, Connecticut, managed about $1 billion at the beginning of 2008, Bloomberg said. The news agency said JWM's London chief Adrian Eterovic plans to start his own fund. Eterovic registered Episteme Capital Partners (U.K.) LLP with the U.K.'s Financial Services Authority, the report said. (Reporting by Hezron Selvi in Bangalore; Editing by Valerie Lee)

Jan, 10, 2009 - The Long Term Capital story, from the PBS special, "The Trillion Dollar Bet." 

   See the transcript here.

Dec 14, 2008 - Superwoman' stung by hedge fund guru's '$50bn trading scam

Dec 04, 2008:

Jun 12, 2008:

Click to read the Forbes article.

The Forbes Cover Story


June, 2008: Warren Buffett bet $1 million against hedge fund success.

April 01, 2008: Hedge-fund Hemorrhage 

William F. Sharpe, Nobel Laureate Click Here Nov. 2005: Hidden Risks of Hedge Funds - Stanford GSB 10 to 1 leverage means 10 x the standard deviation of the non-leveraged or equity portion.

Mar 11, 2008 "...said that such funds were 'snapping like twigs', with one failing every day. " 

March 12, 2008: Hedge Fund Losses: Drake mulls options after hedge fund losses

Read about Hedge Funds - (Defined) - (another definition) and Private Equity

Mar 10, 2008: Survey of Due Diligence Practices Among Investors in Alternative Investments - "Has your organization ever decided not to invest with a manager because of allegations of unethical behavior?" a whopping 81.4 percent answered "Yes." 

Mar 04, 2008: Peloton Partners: Unusually Large Risk-Management Staff Asleep at the Switch 


Feb 15, 2008: Hedge Funds: Risk and Return - Financial Analysts Journal Burton G. Malkiel and Atanu Saha 

1. Risk Management for Hedge Funds - Andrew Lo, MIT

2. Do Hedge Funds Increase
Systemic Risk?
 Andrew Lo, MIT and others

3. Hedge Funds: Who'll Take the Toxic Waste? 

4. The Uncertainty of Returns - Amaranth's Losses Top $6 Billion

5. Hedge Funds: Superstars or Average Joes? - Not Good News!

6. Private Equity Returns of 746 funds over 17 years approximately equals S&P 500 Returns

7. Like Hedge Funds? Read This First! - PDF Version 

8. Hedge Funds - from Ben Stein 

9. 2 20 = market returns at best 

10. Hedge Clipping - The New Yorker

11. How to Beat Hedge Funds

Download This Presentation:

IFA's Concern with Hedge Funds

 

Conclusion

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 tuition bill. If you have reviewed all the information above and still want to invest in hedge funds, please call an IFA advisor at 888-643-3133 and maybe we can help you evaluate the risks and odds of success.