Once upon a time, hedge funds earned their outsize compensation by, guess what? Hedging their investments. This risk-mitigation strategy reduced the gains when markets were up but avoided some of the losses when markets were down.
Today, most hedge funds have morphed into something very different: aggressive, highly-leveraged, speculative vehicles that are desperately chasing returns to outperform their benchmarks, that make huge returns for the managers regardless of the fund's performance and end up transferring wealth from investors to hedge fund managers
Overall, hedge fund performance is poor
By most measures, hedge funds have failed to keep up with regular markets. According to HFRX Global Hedge Fund Index:
- Hedge funds returned a mere 3.5 percent in 2012, while the S&P 500-stock index gained 16 percent.
- Over the past five years, the hedge fund index lost 13.6 percent, while the indices added 8.6 percent.
- In 2013, most hedge funds have fallen even further behind, gaining 5.4 percent vs. the market’s rally of 15.4 percent.
That’s even before we get to the pesky question of fees. The industry standard fee of “2 and 20” (2 percent annual management fee against the original investment, plus 20 percent of the investment profits) is outrageous compared to average mutual fund fees of 1.44 percent and under 0.25 percent for an index ETF. To add insult to injury, hedge fund managers get a special tax break that enables them to claim that their "2 and 20" fees are capital gains.
These fee arrangements are a wealth transference mechanism, systematically moving money from investors to hedge-fund managers. Some of the statistics amassed by Sinon Lack’s The Hedge Fund Mirage (2012) are astounding:
- From 1998 to 2010, hedge fund managers earned $379 billion in fees. The investors of their funds earned only $70 billion in investing gains.
- Managers kept 84 percent of investment profits, while investors netted only 16 percent.
- One-third of hedge funds are funded through feeder funds and/or fund of funds, which tack on yet another layer of fees. This brings the industry fee total to $440 billion. That's 98 percent of all the investing gains, leaving the people whose capital is at risk with only 2 percent, or $9 billion.
Moreover it can be hard to get your money out of a hedge fund. Many hedge funds are “gated” with only small windows when you can withdraw your money.
The mirage of becoming super rich
Why would any investor hand over their money over to a hedge fund? As Ritholz explains, it’s driven by greed and the swagger of the superstar manager. The illusion of the guy who might make you fabulously wealthy attracts capital. Investing in hedge funds makes no more sense than trying to become a billionaire by gambling big money in Las Vegas.
It’s people like John Paulson, who got publicity when he became a billionaire in 2005-06 and so money flowed in. He was soon managing some $36 billion. But lo and behold, shortly after, he hit the skids, with losses of 52 percent in one fund and 35 percent in another.
Only a small percentage of funds have significantly outperformed the markets; an even smaller percentage have done so after fees are taken into account. And no one has the slightest clue which if any funds will outperform markets over the next decade. As Ritholtz notes, “Every fund in the world warns that past performance is no guarantee of future results. It is too bad that investors refuse to believe it.”
The rational conclusion is obvious: if you want to become fabulously rich, become a hedge fund manager, not a hedge fund investor!
Pension funds are now "gambling on resurrection"
It’s bad enough that regular investors will now be subject to the flim-flam tactics of hedge fund managers. Sadly, underwater pension funds have already succumbed to the lure.
Investing by pension funds in hedge funds is for the most part a feint to conceal the underlying poor performance, or even insolvency of the funds. According to a report from the International Monetary Fund (IMF) issued last month, these moves are part of an alarming trend of “gambling on resurrection.”
Gambling on resurrection is what happens when a fund starts running into financial trouble. The responsible thing for pension fund managers would be to face up to the problem and discuss what to do, accepting the possibility that they may be held accountable for creating the problem.
Many pension funds are now doing the opposite. They gamble on resurrection. They play down the problem and bet big with a high-risk/high-return strategy; if their bets pay off, they're solvent, and if not, well, what the hell? They're already insolvent. And it’s not their own money that they're playing with. With any luck, they'll be out of there long before the problems are obvious.
And read also:
HBR blows the lid on C-Suite compensation
Why another financial crisis is inevitable
The C-suite financial incentives bubble
The five big surprises of radical management
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Steve Denning‘s most recent book is: The Leader’s Guide to Radical Management (Jossey-Bass, 2010).
Follow Steve Denning on Twitter @stevedenning
