Shining the Light on a Dark Corner of the Investment World
The hedge fund industry has always been a nebulous collection of unregulated investment advisers. Hedge funds are free to invest in whatever they want, and not even inform their own clients (let alone any regulators) of their holdings. It doesn’t take much of a leap to suggest that performance reporting by hedge funds should be viewed somewhat skeptically. Yes, the industry has its own index, which tracks the reported performance of most funds in the industry. But even among the reported numbers, there is fertile ground for skepticism.
For example, hedge funds have a lot of discretion to appraise the value of an illiquid investment (one that does not trade, so its value is always unknown), which can be used to smooth out returns. In the case of an ugly bear market, when the value of publicly-traded holdings fall, the value of an illiquid investment can be reported as the same as the previous year. Who’s to say what the value is? But when that happens, the fund’s returns in a down market seem to hold up relatively well. We at Monarch levied the same case against real estate during the housing bubble. While real estate valuations seem to be much less volatile than, say, stocks, this is because the turnover of housing is so infrequent. In actuality, the value of your house is changing all the time, but you never know it until it’s time to sell it.
Then there’s the issue of “survivorship bias.” When a hedge fund’s investments blow up, typically the fund pays out to investors whatever is left, shuts down, and those returns do NOT get reported in the hedge fund index. But investors suffered huge losses nonetheless. The same is true for mutual funds. It’s not as big of a deal to mutual fund investors, who typically base their investment decisions on a fund’s historic returns, rather than mutual fund industry returns. But hedge fund investors are a lot more “top-down” focused, meaning they’ll invest in the asset class (by investing in many different hedge funds), and expect returns similar to historic asset class returns. Yes, there will always be funds that perform very well, but there are as many that blow up.
All of this is relevant to a New York Times article published last weekend, which brought to light a book published early in 2012 called, “The Hedge Fund Mirage,” by Simon Lack. The author was in the hedge fund industry for 23 years, allocating investor capital to hedge funds on behalf of his employer, JP Morgan. His assertions are dramatic, and damning. As we intimated in the first paragraph, hedge fund performance has always been viewed skeptically, so no one should say they’re shocked at his premise. But his calculations put a lot of meat on the bone.
We’ve not read the book yet, but having read the article AND the rebuttal from the hedge fund industry, our opinion of hedge funds is unchanged, and enhanced. In fact, the industry’s 24-page “rebuttal” report essentially acknowledges that most of the book’s assertions are true, but that they would prefer to look at things differently. The industry’s contentions are all supported by calculations which include the glory years of the 1990s and 2000-02, when hedge funds were still a fringe strategy. Since they became more mainstream, and money poured into them in the 2000s, returns have been undeniably weak.
The noble objective of most hedge funds has been to produce a solid absolute return, in good times and bad. Thus, it should be expected that their performance relative to stocks would look good in bear markets, but lackluster in bull markets. Given their early success, showing the ability to protect the downside in bear markets, but also capture most of the upside in good markets, the industry was able to establish a very hefty fee structure, typically 1% or 2% of assets, plus 20% of all gains. So, if your investments produced a “pretty good” +10% return in a year, you would expect to see only about 7% of that return, with 3% going to the fund manager. [Even the most unethical investment advisor or mutual fund manager would blush at such fees.] Solid results throughout the 1990s and into the bear market of 2000-02 allowed the hedge fund industry to lock up that fee structure, and made way for the creation of a vast infrastructure to market the industry.
Since then, as even the hedge fund industry’s lobbying group points out, returns have been less than mediocre. First of all, they failed to protect downside in 2008, posting a -23% return on average (a figure which ignores survivorship bias). In good years, returns have generally been in the low-single digits. Why so weak? The biggest reason is, as the author states, early hedge funds proved adept at unearthing a lot of the market’s inefficiencies. Trying to explain what market inefficiencies are would take way more time and energy than we have, but suffice it to say that the more people there are looking for them, the less effective these methods are.
The elephant in the room is that BONDS have always been designed to do what hedge funds have failed to do: provide downside protection to part of an investor’s portfolio. We are unabashed supporters of structuring customized portfolios for our customers, and we still believe in equities and bonds as the primary asset classes to accomplish our customers’ financial objectives. Minor asset classes can have appeal as a minor share of a customer’s portfolio. But hedge funds have underperformed a simple 60/40 mix of stocks and bonds every single year in the last 10 years, from 2003-2012. The data should give investors pause in considering the use of hedge funds at all, let alone for justifying the industry’s ridiculous fees.
Here’s the New York Times article: