Man Looking

Should Hedge Funds Get Away With It? Not on Our Watch!

Man Looking

The title above is a play on the title of this excellent article from the venerable New Yorker magazine which offers eight possible explanations for what Barry Ritholtz brilliantly calls The Most Fascinating Investing Paradox—that qualified investors keep pouring money into hedge funds despite their disappointing performance. At the end of both articles, Simon Lack, the author of The Hedge Fund Mirage and one of our favorite commentators on hedge funds, is quoted as saying, “It is an amazing disconnect. The entire hedge fund industry is designed to channel assets into hedge funds. Everyone—consultants, advisers, funds of funds, capital introduction groups of prime brokers—recommends investing in hedge funds. Nobody is providing the opposite view.”

The purpose of this article is to summarize how IFA, like Mr. Lack, has strived to provide the opposite view through videos, presentations, and articles.

We begin with a series of three videos about hedge funds that discuss the non-linear risks and the fee structure that works to the disadvantage of investors. The second video features an interview with the Head of Research and Co-Chief Investment Officer of Dimensional Fund Advisors, Gerard O’Reilly, who discusses the impact of leverage and the problems with the returns reported to hedge fund databases that suffer from survivorship and backfill bias.

The first video above sourced some of its data and quotes from this presentation which we have often used to convince clients and prospects to step back from “the ledge.” Regarding articles, here are some that we have published the last three years that make a powerful case against investing in hedge funds:

Hedge Funds: A Deeper Look into their Returns

This article summarizes data from a Financial Analysts Journal showing the large impact of reporting biases on hedge fund returns data, especially survivorship bias. It also shows how the high fees erode returns received by investors, and how the majority of the returns of the surviving hedge funds are explained by their exposure to risk rather than manager skill.

Hedge Fund Warnings from the SEC

This article summarizes this SEC Investor Bulletin which admonishes “accredited investors” to carefully research any hedge fund in which they are considering an investment. This would include an understanding of the fund’s investment strategy including the extent to which it relies on leverage and short-selling, its fee structure, the custody of the assets, and the background of the manager(s). Lastly, the bulletin discusses several hedge funds that turned out to be Ponzi schemes, which brings us to our next article:

IFA’s Ever-Expanding Hedge Fund Manager Hall of Shame

This special exhibit was created by IFA to help us keep track of what Forbes called The Sleaziest Show on Earth. We currently have 23 managers listed, and many of them have been topics of CNBC’s American Greed. Several of them are connected to the SAC Capital Insider Trading Scandal.

2013: Another Dismal Year for Hedge Funds, Tough Times for Alternative Investment Strategies and Hedge Funds, and More Troubled Waters for Hedge Funds

These three articles highlight the recent difficulties faced by investors attempting to obtain reasonable risk-adjusted returns from their hedge fund investments. The second one delves into the “poor man’s hedge fund” otherwise known as alternative-based mutual funds or exchange-traded funds. Their performance has indeed left their investors feeling much poorer than if they had simply gone with boring index funds. The third one discusses how certain large investors (e.g. the $300 billion CalPERS fund) have decided to abandon hedge funds.

The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to Be True

Lastly, we feel obligated to mention our review of Simon Lack’s book which we consider required reading for anybody who is currently invested or is contemplating an investment in a hedge fund. Lack shows that hedge fund investors as a group would have been better off if they had simply bought Treasury bills, the quintessential risk-free investment. Lack also decries the imbalance between fees paid to managers and returns received by investors. Specifically, Lack found that since 1998, hedge fund managers have kept 84% of profits, leaving paltry 16% for investors. We look forward to an updated edition of this book, but in the meantime, we will continue to do all that we can to educate investors regarding the dangers of hedge funds and other alternative investments.