Money and Magnifying Glass (Photo credit: Images_of_Money)
There’s a public debate raging about the pros and cons of hedge funds—not any individual hedge fund, mind you, but rather hedge funds in general.
There’s been plenty of skeptical talk in my circles. As a whole, the industry has produced very lackluster returns over the past couple of years, with the S&P 500 index clobbering the leading aggregate hedge-fund index. In 2012, the HFN Hedge Fund Aggregate Index was up 6.65 percent while the S&P 500 was up 16 percent. In 2011, the same hedge fund index had a return of -4.5 percent while the S&P 500 was up 2.11 percent. A well-reviewed new book by hedge-fund veteran Simon Lack, The Hedge Fund Mirage, argues that “if all the money that’s ever been invested in hedge funds had been put in Treasury bills instead, the results would be twice as good.” Meanwhile, SAC Capital, the famous Connecticut hedge fund founded by Steven Cohen, shelled out $616 million this month to government-securities regulators to settle insider-trading lawsuits. It's longtime portfolio manager was arrested last week.
So are hedge funds all bad? I decided to ask my friend Brian Portnoy, one of the country’s foremost experts on hedge funds, for his take. A CFA with a Ph.D. from the University of Chicago, Portnoy is a sought-after due-diligence man who specializes in scrutinizing hedge funds. His book, The Investor’s Paradox, is coming out soon and he makes a lot of sense on the history of hedge funds, how they work and how people and institutions make decisions about which ones to buy.
I assumed he and Simon Lack would be natural allies. But one of Portnoy’s complaints (sorry, couldn’t resist) is directed at Lack. “Lack supports his case with plenty of hard data, most of which is damning on its face,” he says. But “when we review his verifiable arguments versus his more impressionist views on friends and trends in the industry, we arrive at one nagging problem with the analysis: It is almost completely wrong.”
Portnoy shared with me his forthcoming review of Lack’s book. Here’s an excerpt:
Take [Lack’s] bold opening claim that U.S. Treasuries have been a much better investment than hedge funds. To support that claim, Lack relies heavily on an academic study by Dichev and Yu (2009), “Higher Risk, Lower Returns: What Hedge Fund Investors Really Earn,” which takes a statistically informed look at the real experience of hedge fund investors. They conclude that such investors earn returns that are unsatisfactory. Theirs is a reasonable analysis. But it is hardly the appropriate citation for Lack’s claim. As Dichev and Yu state right up front in the abstract of their article (i.e., not hard to find and difficult to misread), hedge fund returns during the sample period “are only marginally higher than the risk-free rate as of the end of 2008.” In other words, hedge funds beat T-bills over time, not lagged, let alone lagged by half.
Portnoy also objects to Lack’s use of “dollar-weighted returns” to measure hedge funds’ performance. The method accounts for the fact that most investors drift in and out of these funds as they get hot or cold, rather than sticking with them through thick and thin:
There is no more basic lesson in finance than to “buy low, sell high.” Unfortunately, most of us don’t act that way consistently. For a number of behavioral considerations we often do the opposite. We might get excited about good performance and want to join in on a “winning” trade; by the same token, we feel unsettled buying something that is struggling and defer investing at depressed valuations. But here’s the rub: If I buy a high quality but volatile mutual fund like Fairholme (FAIRX) after seeing fabulous past returns, then lose faith and sell after awful returns in 2011, only to subsequently miss a huge rebound in 2012, my DWR is awful, but Fairholme’s overall TWR is not. That’s on me, not Bruce Berkowitz.
Lack’s main statistical argument relies heavily on this DWR framing, which is simply inappropriate for liquid or semi-liquid securities (though may be more appropriate for truly illiquid investments like private equity). It’s simply the wrong way to think about the issue, which is why the numbers don’t add up.
I can’t shrug off Lack’s criticism of the overall profitability of hedge funds in general quite as roundly as Portnoy does. The fact is, many investors leapfrog from one hot hedge fund to the next. Even if the disappointment they experience in the end is mostly their own fault, that doesn’t mean the disappointment isn’t real. Nor does it change the fact that they might have been better off pouring their wealth into other, more liquid, less expensive investments.
Still, it’s ridiculous to make sweeping generalizations about hedge funds, declaring that they’re all good or all bad. As with any other type of security, there are some that are really good and there are some that are really bad, and there are a lot that are just OK. The wealthy clients of my firm, Arete Wealth Management, rely on us to go out there and figure out which are the best hedge funds to invest in to the extent that the client wants/needs/is appropriate for hedge funds. I’m convinced that 80 percent of hedge funds aren’t worth it. But one in five is.
If you're not ready to ban hedge funds from your investing life, there's the crucial question of how you vet them. Here are some of the steps in the process we use:
Don’t bother playing with the losers. There are just too many hedge funds now to look at them all. And why bother paying 2 & 20 (2 percent annual management fee plus 20 percent of the profits) if you’re not getting something truly superior? Superior performance (either in terms of top-line gross returns or in risk-adjusted, non-correlation terms) is the only compelling reason to invest in a hedge fund as opposed to publicly registered securities, which will generally have better liquidity and transparency. So eliminate any fund that doesn’t have either a track record of total returns that just blow away the indexes or a track record of exceptionally strong risk-adjusted returns where the Sharpe Ratio (rate of return minus the risk-free rate of return divided by standard deviation) is very high and correlation to other indexes is very low. This approach immediately eliminates probably 80 percent of all hedge funds from further evaluation.
Knock on doors, press some flesh and stare people down. Next, we physically go to the hedge-fund offices, meet all the key people and have a tour around the place. You’ve got to get on the ground and shake people’s hands, look them in the eye and get to know who you might be putting your money with. (Not to kick a dead pony, but if all Bernie Madoff’s investors had gone to his office to physically see all the “traders,” I’ll bet many of them wouldn’t have poured their millions into his fund.)
Be an accounting stickler. We won’t bless any hedge fund that doesn’t have a third-party financial audit every year performed in accordance with the standards of the Public Company Accounting Oversight Board, created by Congress as part of the Sarbanes-Oxley Act of 2002. These days, both FINRA and the SEC pretty much expect this.
Measure their measuring stick. The temptation for a hedge fund to fudge its numbers is significant. The hedge fund’s methods for tabulating its performance should comply with Global Investment Performance Standards, a set of rules established by the CFA Institute, and audited by a third party for accuracy. Because it’s fairly costly to get a GIPS-compliant audit done, unfortunately a lot of newer hedge funds we find have not done this yet.
Shrug at how the fund says it would have performed way back when. Particularly if the hedge fund is newer, they often will use performance numbers that are “backtested,” where they apply their models or algorithms to the past even if the fund didn’t exist then. We insist on a GIPS-compliant audit on these numbers, but even then we put less faith in them. The upshot is that we prefer funds with longer track records.
Beware the geeks. If the fund uses quantitative algorithms for its strategy, we meet with the strategist and the programmer. If they can’t explain their strategy in way that make sense—have them go through it twice if you have to—forget it.
Find a fellow traveler. We sometimes like to partner with other large family offices that have also done a ton of due diligence and invest with them into a fund of funds. Two heads are better than one.
Make friendship an issue. The more we know the manager the better. We want to play golf, have meals, go sailing and generally spend as much time with the managers as possible. You really get to know people once they’ve got a few libations in them. As Pliny the Elder said, in vino veritas. The fact is, a manager who sees you as a friend is going to try that much harder to tell you the truth about the fund and its prospects.
If you think all that sounds too difficult, don't invest in any hedge fund. There are dangers—and most investment firms with regular contact with hedge funds have a battle scar or two to prove it. In 2008 the assets of a hedge fund we had invested in were seized by the SEC. We had alerted regulators to discoveries that we made in our ongoing due diligence—the fund misrepresented the educational credentials of the president of its holding company and which law firms and accounting firms were advising it. The regulators then discovered that the president of the holding company had been involved in improperly commingling assets from one fund to cover losses in other funds. Fortunately, our clients did get some of their money back.
Needless to say, the suggestions I’m giving have been hard learned from numerous years in the trenches. Readers of my column will see one of my recurring themes emerging here: You’ve got to do the hard-core, physical due diligence on investments. The closer they are, in proximity and in friendship, the better. There are no easy generalizations about investments—there are great ones in every asset class and security type. But you have to dive deep to uncover them.
