Is That Hedge Fund Really Worth It?

Is That Hedge Fund Really Worth It?

Simon Lack, author of The Hedge Fund Mirage, and previously a member of J. P. Morgan’s hedge fund due-diligence team in the early 1990s, argues that hedge funds are overpriced, non-transparent, and provide poor returns over time.  During a talk at the CFA Institute’s annual conference in Seattle earlier this year he explained that hedge funds suffer from some of the same problems as actively managed mutual funds.  Their managers claim to be able to take advantage of market inefficiencies, improve diversification, and provide lower correlations to more traditional investments. But the bigger the funds grow, the harder it becomes to make a difference.   Over time hedge fund returns tend to average out.  This is known in the investing world as reversion to the mean, and the statistics bear this out.  Only 7% of hedge funds were in the top 40% of the industry in every year of Lack’s data sample, which began in 1998.  He pointed out that since 2002 not one hedge fund has outperformed a simple 60/40 stock/bond portfolio each and every year.

That fact alone should give prospective hedge fund investors pause.  Then there’s the lack of transparency, which hedge fund managers claim is necessary to protect proprietary information.  With so little information publicly available, how is an investor supposed to evaluate a fund or fund manager?  Past performance?  With mean reversion so prevalent, good luck finding the consistent outperformers.

But that’s not what’s especially eye-popping from Lack’s presentation.  It’s the cost that hedge fund investors are paying for the privilege of owning those types of funds.  Lack determined that after subtracting all fees, hedge fund investors received about 5% of hedge fund total profits over the last fifteen years, with the rest going to the hedge fund managers.  Contrast that with actively-managed mutual funds.  According to data from NerdWallet, the average actively-managed fund returned 7.57% annually over the last ten years, of which 1.07% went towards fees.  In other words, over 85% of the returns went to investors, with the fund managers keeping only about 15%.

With numbers like that, it’s no wonder the hedge fund industry is growing.  Being a hedge fund manager is clearly a very lucrative job.  John Paulson of Paulson & Company, one of the hedge fund industry’s largest firms, earned $2.3 billion last year, according to Institutional Investor’s annual ranking.  But don’t count on longevity.  According to Hedge Fund Research (HFR), a company that tracks hedge funds, a hedge fund that survives the twelve-month mark lasts on average only about five years.  In 2013 almost a tenth (904) of all hedge funds were liquidated.  More than two-thirds of all hedge funds that have ever existed are currently dead and gone.  That’s a fact that you won’t find in any hedge fund industry promotional material.

As I’ve written before, with so many publicly-traded mutual funds and ETFs available today, you ought to be able to find one that addresses whatever investment space you prefer, with better liquidity, higher visibility, and much lower cost than any hedge fund.  There are even ETFs available today that track hedge funds, allowing you to participate in hedge fund performance without incurring all those limitations.  If you are currently a hedge fund investor, have you investigated those alternatives?

You can see Lack’s presentation here: http://advisorperspectives.com/newsletters14/pdfs/lack.simon.pmg.pdf

Here’s a link to the NerdWallet data: http://www.nerdwallet.com/blog/investing/2013/active-mutual-fund-managers-beat-market-index/

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