Hedge Funds: Are They For Everyone?

I'm speaking on a panel today at Lipper HedgeWorld with Ed Easterling of Crestmont Research and Ron Geffner of Sadis & Goldberg LLC.  "Are Hedge Funds For Everyone?"  My answer is "no."

I should say upfront that I am viewing this question from the perpective of those who invest in hedge funds. From the perspective of those who own or work for hedge funds, they are probably the best business in the history of the world (and I would have said this even before today's New York Times reported how much the top 25 managers took home in 2006). 

On the investor side, if one could consistently identify the top hedge funds in advance and be confident that performance that looked fine in one market environment (up) would persist in another (down), the answer would be "Yes--hedge funds are for everyone."  The trouble is that the top funds are hard to identify in advance, even for those with the necessary time, money, and expertise, and many of the best ones are closed to new investors (especially small investors).  This means that most hedge-fund investors will likely be choosing from funds that are merely above-average, average, or below average.  And, there, the picture isn't so pretty. 

Recent academic research suggests that, on average, hedge funds generally produce lower returns and have higher risk than most people think.  Gross performance is blunted by high fees and increasing competition: So much brainpower competes in the hedge-fund industry these days that even brilliant managers often can't overcome the drag of 2-and-20 fees (2% of assets and 20% of gains).  Average hedge-fund risk, meanwhile, is harder to measure than, say, average mutual fund risk, and research suggests that, on average, the likelihood of "extreme negative events" is higher than a standard mean-variance analysis would suggest.  The same research suggests that hedge funds' diversification benefit is often overstated.

The primary drawback of hedge funds, in my opinion, is that the compensation structure often rewards managers who produce results that are no better than one would receive in a low-cost passive strategy: many investors pay 2-and-20 for gross performance they could have bought for 20 basis points.  Currently, some hedge funds do offer investors the ability to invest in risks and opportunities that aren't accessible with passive products.  Within a few years, however, I think it's likely that Wall Street will develop passive products that can replicate (or track) the returns of all but the best hedge funds at far lower cost.  At that point, hedge funds might be "for everyone." 

Until then, however, Jack Bogle's logic holds: the net return to investors equals the gross return minus costs.  And, historically anyway, most hedge funds managers have not produced performance strong enough to overcome their fees.

I discussed these points in some detail in the Wall Street Self-Defense Manual and this recent Slate piece.  Below are links to some of the recent research on the topic:

• Hedge Funds: An Industry in its Adolescence, by William Fung and David Hsieh, 2006.  Excellent overview.  Fung and Hsieh have written numerous papers about the performance and risk-characteristics of hedge funds, many of which can be found here.

• Hedge Funds: Risk and Return, by Burton Malkiel and Atanu Saha.  Argues that hedge funds have lower performance and higher risk than is commonly thought.  This article was immediately attacked by the hedge-fund industry, but, in my opinion, most of the counter-points were not persuasive.

• 10 Things Investors Should Know About Hedge Funds, by Harry M. Kat.  Explodes some of the myths about hedge funds (great diversification!) and discusses the challenges of correctly assessing risk, portfolio impact, etc.

• Hedge Fund Benchmarks: A Risk-Based Approach, by William Fung and David Hsieh, 2004.  An examination of hedge-fund returns using "style-based factors".  Shows that most hedge fund returns can be explained by the performance of the particular strategy, rather than the manager's unique skill.

Comments

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No I don't think that hedge funds would be good for everyone, we all have different needs.

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