ACTIONABLE ADVICE FOR FINANCIAL ADVISORS: Newsletters and Commentaries Focused on Investment Strategy

Follow us on

Exclusive Sponsorships

Most Popular This Month

Most Popular This Year

Why Hedge Funds Destroy Investor Wealth

August 7, 2012

by Michael Edesess

Simon Lack’s hedge fund performance observation

And yet Mr. Lack’s assertion about the relative merits of hedge funds and Treasury bills is not even based on any of these database flaws. Instead, it is a result of the fact that most hedge fund investors put their money in hedge funds only after the funds’ performance – or at least their apparent performance – was good; but funds’ performance often becomes awful after they are bloated with that new money. That alone is enough to support Lack’s statement that the average dollar invested in hedge funds underperformed what it would have earned in US Treasury bills.

This was not always so. Lack writes, “In the first three years of the new millennium, the compounded return on the S&P 500 was -37 percent, while hedge funds (as measured by HFR Global Hedge Fund Index [HFRX]) generated a compound return of +30 percent.”

We need to adjust the HFRX number way downward to account for all those biases, but it still seems justified to say of hedge funds, as Lack does, that “from 2000 to 2002, they genuinely added value.”

In the years 2000-2002, however, the total dollar amount invested in hedge funds, according to BarclayHedge, averaged only about $300 billion. By 2007-2008, the amount invested was more than six times that, just in time for a negative 23% return in the year 2008. Hence, much more money was invested in hedge funds when they performed poorly than when they performed well.

This way of looking at it – calculating the return that the average dollar invested in hedge funds has realized historically – is called an asset-weighted return. It is calculated differently from the rates of return that most hedge fund performance studies report. Those studies use time-weighted returns, which, roughly speaking, assume that the same amount is invested in every period. Hence, in those studies, the 2007-2008 down period counts the same as the 2000-2002 up period, not six times as much, as it does in Lack’s calculations.

That is why Lack’s critic, AIMA chief executive Andrew Baker, says in his article, “asset-weighted figures tell us more about investor behavior than manager performance.” What he means is that if investors choose to plunk six times as much money into hedge funds just before a year when hedge funds happen to perform abysmally, that’s their fault and not the managers’.

Lack argues that the problem is that hedge funds perform well only when they are small; when they grow big, they can’t perform as well. (He doesn’t quantify how small is advisable.) Hedge funds performed better ten years ago because, according to Lack, “Funds were smaller and, as a result, many strategies were available that simply don’t scale with the size of today’s industry.” As for the hedge fund investors, “Small hedge funds got them interested, but large funds are where they go” – because the ones that have grown large are the ones that are better-known for their past performance. Managers abet this trend. Even though they are partly compensated in proportion to their performance, fund managers can still maximize profits by accepting more and more assets and performing less well – and they do.

If it is true that small hedge funds perform better, but most of investors’ funds are in the large ones, then the standard average hedge fund performance measures are truly unrepresentative of the performance of the average dollar. Those measures usually equally weight hedge funds – thus giving equal weight to the small ones and the large ones, not greater weight to the large ones – and they weigh the earlier years of hedge fund performance equally with the later years, giving the same weights to the period when the total amount invested in hedge funds was small and the period when the amount was much larger.

I do have some doubts about Lack’s thesis about small hedge funds. Certainly, the ones that do best are likely to be small – their mission is to find an inefficient market niche in which unusual returns can be realized as the market becomes more efficient, and such strategies can only scale up so much. But there are certainly many small funds that never get off the ground and we never hear about; I have myself been informed about fledgling funds that I knew for sure were applying a senseless strategy. So just because a fund is small is not reason enough to invest in it. Smallness is not a sufficient condition for a hedge fund to execute a highly successful strategy, though it may be a necessary one.