A hedge fund for you and me? The best move is to take a pass
Barry Ritholtz
Washington Post May 24 2013



Earlier this year, Goldman Sachs Asset Management announced that it would launch a new mutual fund that — apparently — will bring the joy of hedge fund investing to the masses. For as little as $1,000, the Multi-Manager Alternatives Fund (GMAMX) allows mom-and-pop investors to put their life savings into some of Wall Street’s riskiest and most expensive products. This “fund of funds” will, according to its prospectus, let investors gain exposure to the trading strategies of hedge funds.

The obvious question is: “Why would investors want that?”

Despite all the media coverage, glitz and glam of hedge funds, they have not done well for their investors. They have high — some say excessively high — fees; their short- and long-term performance has been poor.

Before delving into the details, let’s define exactly what we are discussing: Hedge funds are private investment partnerships. The general partner is typically the fund manager (on occasion it includes his financial backers). The investors in the fund are the limited partners, normally institutions and accredited investors. This partnership structure typically has a max of 99 limited partners. Unlike mutual funds or brokerages, hedge funds are mostly unregulated.

The global hedge fund industry manages $2.13 trillion, or about 1.1 percent of all assets held by financial institutions, according to the Coalition of Private Investment Companies. Given what a relatively small asset class this is, hedge funds certainly receive an excess of media attention. Many hedge fund managers have become billionaires; perhaps this — plus their reputations as the smartest guys in the room — is why they have captured the investing public’s imagination.

Most hedge funds are “go anywhere” funds — they can own derivatives, mortgage-backed securities, credit-default swaps, structured products and illiquid assets. They also can use nearly unlimited leverage.

Gee, that sounds kinda hazardous. Why would anyone want to assume all of that risk? Originally, hedge funds earned their outsize compensation by, well, hedging their investments. This is a risk-mitigation strategy that can reduce the gains investors reap when markets are up but avoids much of the losses when markets are down.

That no longer seems to be the case with modern hedge funds. They have morphed into “absolute return” funds — more aggressive, greater leverage, more speculative, all in an attempt to generate returns that outperform their benchmarks. Not surprisingly, they have become riskier than the overall market.

Given these increased risks (and higher fees), how have hedge funds performed?

By most measures, not well. They have failed to keep up with major averages when markets were up — and they got mangled (like nearly everyone else) during the 2008-09 downturn. It turns out, most hedge funds are not very hedged.

The latest performance data (via the HFRX Global Hedge Fund Index) reveal that hedge funds haven’t fared well at all: They returned a mere 3.5 percent in 2012, while the S&P 500-stock index gained 16 percent. Over the past five years, and the hedge fund index lost 13.6 percent, while the indices added 8.6 percent. That’s as of the end of 2012; it has only gotten worse in 2013. Most hedge funds have fallen even further behind their benchmarks this year, gaining 5.4 percent vs. the market’s rally of 15.4 percent. As a source of comparison, the average mutual fund is up 14.8 percent.

Which brings us to fees. Most hedge funds charge an industry standard “2 and 20.” This is a 2 percent annual management fee against the original investment, plus 20 percent of the investment profits. Compare this with annual mutual fund fees, which average about 1.44 percent. Fees for an index ETF are typically under 0.25 percent.

Those outsize hedge fund fees are an enormous drag on performance. But they do create wealth — for the managers. “Two and twenty” as the industry calls it, is why even middling hedge fund managers can become billionaires. According to Simon Lack, author of “The Hedge Fund Mirage,” this fee arrangement is effectively a wealth transference mechanism, moving dollars from investors to managers. As he puts it: “While the hedge fund industry has generated fabulous wealth and created many fortunes, it has largely done so for itself.”

Lack is no ordinary critic — he spent his career at JPMorgan Chase, where he allocated more than $1 billion to emerging hedge fund managers. Some of the statistics he amassed in the process are nothing short of astonishing:

●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.

●As many as 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.

What other concerns should investors have? Hedge funds are not especially liquid. Many are “gated” — meaning there are only small windows when you can withdraw your money. They typically have a high minimum investment and often require investors keep their money in the fund for at least one year.

Why would anyone in their right mind invest in these funds?

So many kids dream of becoming LeBron James, but most will never play in the NBA (to say nothing of amassing championship rings). So it also goes with hedge fund investors. Most of the more than 10,000 hedge funds out in the wild are not big moneymakers for their investors. Investors tend to discover “hot” mutual fund managers just after a successful run and just before the inescapable force of mean reversion is about to kick in. Similarly, hedge fund darlings are born at exactly the same moment in their trajectory.

John Paulson is a classic example. The bet against subprime mortgages that he and Paolo Pellegrini created in 2005-06 put them on the map and turned Paulson into a billionaire. He became widely known, and the money flowed in. Within a few years, Paulson was managing a slew of hedge funds, and his assets under management had swelled to $36 billion. Soon after, he hit the skids, with losses of 52 percent in one fund and 35 percent in another.

But the lure of the superstar manager — the guy who can make you fabulously wealthy – continues to attract capital. In 1997, $118 billion was managed by hedgies; as of the first quarter of 2012, that had grown to $2.04 trillion.

Investors have also embraced other non-financial remunerations: Client-only market commentary, access to star managers, attendance at exclusive conferences. These perks generate cocktail party bragging rights, despite the poor performance.

But what about the top-performing funds, such as Jim Simon’s Renaissance Technologies or Ray Dalio’s Bridgewater? Sure, give them a call.

The Lebron James of hedge fund managers are few and far between. This is the crux of the issue with hedge funds. A small percentage have significantly outperformed the markets; an even smaller percentage have done so after fees are taken into account. While we all know which ones have outperformed over the past few decades, no one has even the slightest clue which ones will outperform over the next one. It is akin to picking out from the ranks of high school sophomores who will be the next NBA superstar. Best of luck with that.

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.


Ritholtz is CEO of FusionIQ, a quantitative research firm. He is the author of “Bailout Nation” and runs a finance blog, the Big Picture.

Category: Hedge Funds, Investing, Really, really bad calls

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

11 Responses to “Why Do You Want To Be A Hedge Fund Investor?”

  1. Theravadin says:

    Yup – was doing some business with a hedge fund manager some years ago. Just out of curiosity I asked him what his hedging strategy was. The response was a blank look. Not a “we never reveal that information” blank look… more of a “whadya talking about” blank look. His fund was generally pretty well regarded… but that was before 2008.

  2. euromodehedge says:

    You are giving Hedge Funds a bad name. Our Fund “euromodehedge” does not charge any management or service fees. Plus we are the most liquid fund with a 5 day redemption notice. Did I mention our 25% return paid out monthly? Like everything in life, please don’t lump us all together.

  3. Joe says:

    It’s great that you’ve gotten this out to the WP. It is out to the public at large who are unlikely to see this here that this will do the most good.

    I think that the obvious question is not about why investors would want this, but is instead, “Is this not the greatest new product to add to the salesman’s inventory for the benefit of the salesman/broker”?

    For the sales staff:
    Entree to an exclusive to the rich investing practice, heretofore denied to everyday clients.
    A product from one of the biggest names in the industry. What could possibly go wrong?
    Is your client taken with Tudor Jones/Robinhood Foundation episode on “60 Minutes”? Allow them to become part of the hedge fund community at low cost.
    Screw the client only to the bounds of your conscience at that particular day/time; size the portfolio allocation to this investment anywhere from minor flesh wound to a gaping hole below the waterline. All with an eye toward “Can’t hardly get in trouble putting an “appropriate” allocation to a higher horsepower strategy”.
    We won’t talk about comes back from the MMA Fund to the broker who places his client in this…nudge nudge, wink wink.

    I’m a believer that investment success comes in part as much from skepticism and sales resistance and the ability not to fall inna obvious hole as brilliance.

  4. bmillerrad says:

    Barry, I’m disappointed, there are so many old trite “truthism’s” in your piece. Hedge funds do charge large fee’s, why? The same reason a dog…..never mind. The weak part of this piece, and that of Simon Lack’s book of baloney, is that if you use the numbers for the “industry”, you are looking at median, or average returns. And guess what, there are an awful lot of really bad hedge fund managers. I feel sorry for the people who invest with them, but a lot of the problem is their manager selection. HF’s “dispersion” of returns is no different that what you see in VC’s, LBO shop’s, mutual funds, and money managers of all description, you need to be able to invest with the top quartile. If your funds or managers keep ending up in the bottom quartile is the problem them or you? While it is true that hot managers of all stripes end up reverting to the mean at some point, it is less of an issue with HF’s than it is for the others mentioned already. They have high “persistency” than the others. Why? Because they are better at it. Some are better stock pickers and hedgers, and it shows in the numbers. The average major leaguer bats less than 300, way less, but there is a group of guy’s, not sure the ranking , (top quartile ?), who bat above 300 for their career. Same for HF’s. Nobody likes to pay high fee’s, but when you get a better return than the stock market (net of fee’s), with lower vol, and little or no correlation to the S&P, does it really matter what the fee’s are? Net net, your portfolio is better off paying them.

    • If you want to produce some data that shows the dispersion, I am happy to see it. Otherwise, the poor performance + the high fees = an investing error.

      (The data is really disappointing, especially if you run a family office . . .)

  5. Winchupuata says:

    Thank you for such a clear post. It’s amazing how much of a ripoff hedge funds are and how people still give them their money.

  6. euromodehedge says:

    Don’t LOL Barry!

    Sorry that I made a mistake in my reply. The Fund provides an annual simple return of 25%. Example, if $100,000 are in the Fund, then the simple annual return is $25,000 or $2,085 paid monthly to the investor. The investment in the Fund remains constant at $100,000. If the investor wishes to leave the Fund, then a 5 day written notice is required, hence our comment about the liquidity for the investor.
    We have been doing this for over 20 years. AND there are no management fees or charges.

  7. euromodehedge says:

    Barry, audited returns mean nothing! ENRON, MF Global, LEHMAN BROTHER, and even BERNIE MADOFF all had audited returns from the “largest and best” accounting firms America has to offer?

    The best information would come from our Investors and the two or three new investors that join the Fund each month based upon recommendations from existing investors.

    The point of my response was to bring light to the fact that Funds do exist that provide a good return on investment without high management fees, or in our case no management fees.

    • Your argument is absurd:

      -Madoff used a nobody one man auditor in east podunk, a red flag a few onservers made as early as 2001.
      -Lehman Brothers Repo 101 and other extra legal actions were made to avoid revealing to investors their capital positions — it had nothing to do with their returns on investments
      -MF GLobal committed theft AFTER their quarterly audits
      -Enron was a scam identifyied by short sellers by reviewing the audit docs.

      Dude, you are destroying what little credibility you had to begin with by making statements like that.

      Your refusal to provide audited returns on a extreme performance claim makes my Spidey sense tingle — there for I am stripping out any mention of your URL throughout the blog, as I do not want to have even the a link to your site.

      I wish the best of luck in the future to you and your investments, but your claims are unproven and your statements about audits are idiotic.

      Good day sir.