Hedge funds employ a variety of management strategies but share some common characteristics – they are structured as limited partnerships frequently marketed to “sophisticated investors”, have a fee structure of a management fee plus a share of the profits (Warren Buffett derisively calls them the 2-and-20 crowd) and are poorly regulated and secretive about their investment strategies. Their fee structure alone is enough in the eyes of many critics to recommend that retail investors stay well clear of these exotic products. But despite the high-profile blowups of Long-Term Capital Management, Amaranth Advisors and numerous others, there is wide spread belief that hedge fund managers can get excess returns because they are “smart”. But, are they?

The authors of a new paper titled The Hedge Fund Game: Incentives, Excess Returns and Piggy-Backing argue that it is difficult for investors to tell the smart managers apart from unskilled ones and it is easy for a con artist to generate “fake alpha” and give a simple example of one such gambit. A more accessible version of the paper is available through Knowledge @ Wharton.

The authors say hedge funds are analogous to an automobile “lemons” market in which lemons can be manufactured at will.

Indeed, it [the hedge fund market] is analogous to a car market with the following characteristics: i) every car is one of a kind; ii) the car’s engine is locked in a black box and no one can see how it works (it’s not protected under patent law); iii) anyone can cobble together a car that delivers apparently superior performance for a period of time and then breaks down completely.

Would you buy such a car?

This article has 22 comments

  1. Thanks for the link!

    Mike

  2. I’ve researched hedge funds and they appear to have a very broad definition, such that it’s hard to determine what is a hedge fund and what isn’t, other than whether or not they charge a performance fee. Some short stocks, some don’t, etc. Also, I don’t think a key attribute of a hedge fund is that it is private and secretive about its holdings. ABC Funds, Sprott Asset Management and Goodwood all have funds that are public and charge both a management fee and a performance fee (Sprott and Goodwood have good long-term track records, but ABC’s haven’t been that good).

    The thing that rankles me about hedge funds are 1) that they charge a management fee even if they lose money or only provide money market returns (but then how different is this from mutual funds that do the same?) and 2) that most do not charge the performance fee based on a ‘high water mark’. A high water mark means that they don’t charge a fee unless the net asset value per share of the fund is higher than any previous high. In this way a fund can’t lose money and then charge you just to get back to the previous high net asset value. Irwin Michael at ABC does not have a high water mark and when I asked him about how unfair this is his answer was incomprehensible (which is unusual, given his no-nonsense style).

    Warren Buffett charged no management fee in any of the partnerships he first started in 1956, but he did charge a 25% fee on any increase in the fund above 6%. So, if he earned a 14% return he would charge 2%. I have been unable to find out definitively whether he had a high water mark but I think he did because he alluded to it at one point in his writings, and this certainly having one would have been congruous with the way he thinks. (Mohnish Pabrai, another very successful performance-based value-fund manager modelled his fund after Buffett’s).

  3. I haven’t had a chance to read the paper yet, but hedge funds are designed to avoid or assuage the problems associated with adverse selection and moral hazard. Most hedge funds employ hostage capital, where the manager makes a sizable investment of their own capital in the fund. Secondly, it’s hard to cover up a reputation of being a bad portfolio manager. If you start up a hedge fund and it goes bust, you are not likely to attract capital for another such venture. Lastly, the performance fee (which is usually subject to a high watermark) is meant to reassure the investor that both their interests and those of the manager are aligned. By comparison, there is less incentive for an active mutual fund manager to outperform their benchmark since they can collect their fund management fees regardless.

    Despite the superior risk-adjusted returns of hedge funds in general (which can be achieved by other means), I can’t see much of a future for certain strategies, such as long-short equity or equity market neutral. Eventually investors who want to build a portfolio with long and short equity will realise that they can do it much more cheaply using ETFs. More specialised strategies though will survive and thrive.

  4. Buy the car? No. Lease the car with a maintenance plan? Maybe.

    Noel makes interesting points.

    I’m currently listening to an intriguing book called the Wisdom of Crowds by James Surowiecki. Sometimes crowds are surprisingly perceptive and other times they aren’t. Since a few investment managers will beat their benchmarks at any given time, there’s a widespread perception that “smart” managers get excess returns. The problem is lack of consistency: the winning managers change.

  5. Canadian Capitalist

    Noel: You’re right that the hedge fund world is muddied (David Swensen says hedge funds must have be a limited partnership and have an incentive fee structure and mostly depend on active management for performance). I’m not very familiar with the other funds but I would call ABC Funds would fail that test because it is long-only and can depend on positive expected returns from equities for hitting some of its performance numbers.

    Robillard: Are there any studies showing that hedge funds as a group have generated superior risk-adjusted returns in the past? I’m not very familiar with the world of hedge funds but J. Meriwether launched another hedge fund immediately after the blowup of LTCM that was again in the news recently due to huge losses.

    Promod: But who would offer a maintenance plan for such a car without steep fees?

  6. Frankly, any investment that does not fully and transparently disclose the nature of its invested capital, and accurately describe its investment strategy is in my opinion garbage.

    Hedge funds and ABCP have all the ear marks of garbage investments.

    If your broker is calling you with the latest and greatest new fad, you really should ask yourself why invest in these new products. If the time frame is long for your investments and you have invested in quality, what reason do you have to invest in some shady undisclosed security that may not even require a prospectus?

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  8. The superior risk adjusted returns comment was something that resulted from the research I did for my honours thesis. I’m sure it must have confirmed what another academic also discovered, but I can’t recall who would have done such research. I can make my paper and its bibliography available if you would like to comb it for interesting information on hedge funds.

  9. I disagree with most of Robillard’s statements. Hedge funds as a group simply do not have superior risk-adjusted returns. This has been reported in the press and in numerous studies. As for a hedge fund going both long and short, many now classify funds that charge both an annual fixed fee (regardless of returns) and a performance-based fee as hedge funds. Also, it is not true that a hedge fund always has a high-water mark. Some have none, some have rolling 2-year high water marks or x-year (wherein after the high-water mark is reset lower).

    I really don’t understand Robillard’s comment that ‘hedge funds are designed to avoid or assuage the problems associated with adverse selection and moral hazard’. Designed not to lose money? Don’t we all wish that was possible! If it was, everyone would follow the hedge fund model. Also, Robillard’s comment that a mutual fund manager has no incentive ‘as they collect their fee regardless’ neglects the reality that mutual fund managers don’t attract more capital if they don’t perform. Also, hedge fund managers also collect their fees even if the fund does not perform. As for the performance fee ensuring that the hedge fund and investor’s interests are aligned, that doesn’t guarantee that superior (or any returns) will be produced. There are many cases of hedge funds blowing up where the manager invested alongside the investors. So the risk of that happening also does not guarantee returns. There are even many cases of hedge fund managers having funds blow up and then going on to raise new ones!

  10. Canadian Capitalist

    Robillard: I’m curious how you obtained data regarding hedge fund performance. My understanding is that any data available is plagued by survivorship bias. David Swensen, for instance, notes that LTCM’s performance from one year prior to its implosion is entirely absent from a leading database of hedge fund data.

  11. Noel, you are missing the point I was getting at. Hedge funds are not “designed to not lose money”. The real problem with hedge funds is that there is asymmetric information between the investor and the manager.

    Adverse selection can be best described as a lemons problem in which an potential buyer cannot differentiate between a good quality asset and a poor quality asset. Moral hazard is unobserved behaviour ex post, which allows the party with superior information to get away with behaviour that would not be allowed under a contract between the two parties.

    To overcome adverse selection, a good hedge fund manager would try to signal to potential investors that they are good managers. Typically this is done by listing in a hedge fund database and posting the fund’s historical returns, but it is a very weak signal, if it has any information value at all.

    The purpose of hostage capital and the performance fee is to overcome the problem of moral hazard. A potential investor is more likely to believe that a hedge fund manager won’t shirk his duties if the investor knows that the manager invests in his own fund, and will only get a bonus if he passes hurdle rate. It doesn’t guarantee superior returns, but it does give the manager incentive to try to earn them.

    Admittedly the definition of hedge fund is rather nebulous. the key characteristics in my opinion are:
    -Freedom from regulatory reporting regulations common to mutual funds
    -Freedom to short securities and trade derivatives
    -Leverage (though some hedge funds are non-leveraged)
    -Barred from advertising to the general public
    -Barred from accepting investment from “non-accredited” investors (though some funds get around this)

    The issue about management fees is a non issue since all pooled investment vehicles charge management fees of some amount and get paid regardless of whether they make money or not. Hedge funds just charge more, though 2% average is not much more than you might pay on some mutual funds or labour-sponsored funds.

  12. CC – actually Brooks and Kat in 2002 found that most data vendors include defunct funds in their databases. Nevertheless survivorship bias is a major concern. Estimates of the effect of the bias range from negligible to the general consensus of 3%. The 3% was the result in a paper by Fung and Hsieh in 2000, so it may be rather dated.

    LTCM was probably not listed in databases in 1997 because they were not trying to attract new capital. Listing is voluntary. Hedge funds typically de-list themselves once they have achieved their ideal portfolio size. This despite the fact that fund managers could earn more by increasing the assets under management. A larger portfolio is harder to re-allocate to opportunities as they arise and may “move the market” when they trade.

  13. Ok well I guess your manner of writing is a bit hard to decipher! But I still don’t see the evidence of hedge funds having superior risk adjusted returns.

    In any event, the issue of management fees cannot be a non-issue, simply because there are many examples of pooled investment vehicles that do not charge management fees, such as Mohnish Pabrai’s fund, which only has a performance fee if the returns are greater than 6%.

  14. Noel,
    From the research I did two years ago for the period 1994- Feb 2006, on an annualised basis, I found that the Sharpe Ratio on the market portfolio was 0.43, that of the S&P 500 was 0.327, and a bond fund I deemed representative of the investment-grade bond category had a Sharpe Ratio of 0.305. By comparison, the CSFB/Tremont Hedge Fund index over that time had a Sharpe Ratio of 0.736. Different hedge fund strategies had wildly different returns to risk though. Nevertheless, as an asset category, for that time period, hedge funds offered better excess returns to risk as measured by standard deviation. This says nothing about hedge fund performance now though.

    As for the statement I made about all pooled investment vehicles having management fees. I guess I stand corrected. Though it does appear that Mr. Pabrai’s fund is not open to unsolicited investment from the general public. My statement should have been limited to publicly available mutual funds.

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  17. Yes not every retail investor should use hedge funds and not every hedge fund offers solid investment opportunities. I think there are reasons why though after investing in hedge funds for 7-10 years now most institutions and ulta-high-net-worth individuals are increasing their allocations to hedge fund managers. Newspapers make it seem like they are all blowing up left and right but I have yet to meet a single journalist who worked in or anywhere near the hedge fund industry.

    – Richard
    Hedge Fund Consulting Blog
    http://richard-wilson.blogspot.com

  18. Canadian Capitalist

    Hi Richard: Thanks for your comment. I refer back to David Swensen’s Unconventional Success who suggests that individual investors simply don’t have the resources to identify high-quality hedge funds that sophisticated institutional investors have.

    Here’s what Warren Buffett told a group of business students in 2005:

    “I’ll tell you what I think of hedge funds. Hedge funds are a huge fad. You can pick any ten hedge funds and I’ll bet that on average they will underperform the S&P over the next ten years. You can’t create more money out of American business than the business itself creates; so most of these hedge funds will not be able to justify their outlandish fees over the long-term and they will disappear. On Wall Street, there are innovators, imitators, and total incompetents. I’m afraid that the majority of hedge funds around the globe now are run by the latter two categories of people.”

    To paraphrase Mr. Buffett, what chance do individual investors have of telling the innovators apart from the imitators and incompetents?

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  20. Further to Robillard’s last comment, Mr. Pabrai’s fund is publicly available and open to unsolicited investment from the general public. You just have to contact him and he’ll take your money (assuming you meet his minimum investment requirement).

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  22. For those looking not to invest in hedge funds, but rather to work for hedge funds there are some great lists available at http://www.hedgefundjoblist.com