The great hedge fund con

According to The Economist, the average hedge fund recorded a gain of 3% last year – miles below the 13% rise in the global equity market. Not very impressive! But the long-term statistics gathered by Hedge Fund Research are even worse.

They show that the total return delivered by hedge funds over the past decade is a feeble 17%, equivalent to barely 1.5% per year. As the Economist points out, this compares to the 90% return that a ‘simple-minded investment portfolio’ of 60% shares and 40% sovereign bonds would have produced. For that matter it is also less than would have been produced by simply plonking the money in the bank and forgetting about it.

The apparent masters of the universe

To call the performance of hedge funds disappointing is an understatement. Hedge fund managers are supposed to be masters of the universe. Super-bright and armed with the latest technological wizardry they are, we are led to believe, far too smart to be confined within old fashioned investment houses.

Allowed to roam free across the whole universe of financial instruments, they are supposed to be able to spot trends before the rest of us and capitalise on market anomalies that mere mortals cannot discern.

For this they have charged a 2% management fee, plus 20% of any profits. An arrangement that looked hugely biased in their favour when hedge funds were launching in their droves over a decade ago, and now looks simply monstrous.

This is a racket, pure and simple, and it has never fooled me. But is has fooled many who should know better. You might think that investors in hedge funds are the super-rich, those with more money than sense and deserving of little sympathy.

But in fact, two-thirds of the assets under hedge fund management come from pension, charitable and other such institutional funds. In other words, this is our money, and thanks to decisions made by the people who oversee these funds, we have all lost billions while hedge fund managers have made a fortune.

Trading is just gambling

I think this is a real scandal. Institutional funds have boards of trustees whose job it is to determine asset allocation and to appoint fund managers. In this they are advised by investment consultants, armed with data based on historic returns and a lot of mumbo-jumbo about risk management.

I say ‘advised’ but I probably should say ‘led by the nose’ because these trustees, who flatter themselves that they have wisdom and sound judgement, are in fact terrified of falling out of line with their peer group. They lap up the hopeless advice of the consultants without having the wit to question it, and fall for all of the marketing of the hedge fund industry.

Let me make it clear. Hedge funds are traders. Traders simply try to make money at the expense of others. Trading is a zero sum game. The hedge fund racket was never going to work. It was doomed to failure, and the larger it became the quicker this would inevitably become apparent.

Trading and investment are two totally different things. Trading is just gambling. Investment means putting your money to work in enterprises that will earn a high return on capital over a number of years. It beggars belief that trustees of institutional funds cannot understand this simple distinction.

Lasting returns come from wealth creating enterprises

Of course, they’re not going to kill the goose that lays the golden egg if they can help it. They say that while the average return of hedge funds might be moderate, some have done very well – a non-argument, as far as I am concerned. They argue that they can borrow money to ‘leverage’ returns and that, of course, can work both ways. But the big argument for hedge funds is one that really makes me mad.

Hedge funds, they say, “reduce risk by providing diversification”. By this they mean “reduce volatility” – but you could achieve this by sticking a part of your money under the mattress. It would do nothing to improve your investment returns.

Dozy fund trustees must now be finally cottoning on to the fact that they have been paying huge fees for hyperactive investment and getting minimal returns. So what will happen next? Those slippery investment consultants will tell them that low cost tracker funds have beaten the active hedge funds. So they will all pile into index trackers, and this will become the next overrated investment fad.

One day fund trustees and investment consultants might understand that real lasting returns come from investment in wealth-creating enterprises and not from trading or artificial constructs of the ever creative financial services industry. But I am not holding my breath….

• This article is taken from Tom Bulford’s free twice-weekly small-cap investment email The Penny Sleuth. Sign up to The Penny Sleuth here.

Information in Penny Sleuth is for general information only and is not intended to be relied upon by individual readers in making (or not making) specific investment decisions. Penny Sleuth is an unregulated product published by Fleet Street Publications Ltd.

11 Responses

  1. 24/01/2013, Faceman wrote

    Tom,

    Surely you are aware and have already been tipped off about the deeper misgivings of this racket?

    Now why would smart, educated, market savvy trustees truly choose to “push” Hedgies and their costs to their respective pools of institutional cash?

    Backhanders are prevalent, I know this as I have worked within this industry in a middle office role, for coming on 15 years.

    A massive story to be exploded in the years to come.

  2. 24/01/2013, Bryan wrote

    How true Mann Group lost me money and are now in the bin

  3. 24/01/2013, southwick wrote

    I speak as a trustee of a pension fund that has made small but very rewarding investments in hedge funds in recent years. There are many different types of hedge funds, and the investor needs to be very selective. There are HFs that are pretty consistently in the top quartile and show decent returns compared to say pure long equities. You need to pick your managers and look at their ethical and trading strategies — not all of them are the “traders” you portray.

  4. 24/01/2013, les wrote

    ur honesty 2help myself+people like me is a breath of fresh air,the world needs people likeu now+alwz.thank u

  5. 25/01/2013, Pete C wrote

    Couldn’t agree more! While a few hedge funds seem to perform well the vast majority seem to deliver hopeless returns – more than a few that I’ve observed have delivered weak (uncorrelated?!) returns when markets have risen but thanks to margin calls have performed as badly (or even worse) when the markets have fallen! Even those hedge funds that do well for a while seem to end up having a bad run eventually. As for charges, the 2% and 20% charging structure obscene as it is, doesn’t include the high transaction costs or borrowing/interest costs associated with these funds. Not to mention the racket of winding up a fund with a poor track record and well below its performance fee high watermark, and launching a “new” fund with a “re-set” high watermark…

  6. 25/01/2013, johnill wrote

    I bought my first hedge well over 15 years ago from what was then ED&F Man. In total I bought six different one, mainly AHL. The first five made me a lot of money, the last one I sold after about 5 years as it was not doing so well, but I still came out ahead.
    I think you should NAME AND SHAME THE ONES YOU ARE TALKING ABOUT. This would save other investors money.
    Keep smiling.

  7. 25/01/2013, Angusleybourne wrote

    agree with Johnill – your comments may well be true of a large number of hedge funds but it would add credibility to your arguments if you NAMED AND SHAMED. How about it.

  8. 25/01/2013, Angusleybourne wrote

    Agree with Johnill – you may be right about many Hedge funds but it would add credibility to your arguments if you NAMED AND SHAMED.
    how about it

  9. 26/01/2013, Paul T wrote

    I have investments in ‘Standard Life Global Absolute Return Strategies’ and they seem to be doing fairly well. They don’t charge fancy fees either. Look up their record for yourself.

  10. 26/01/2013, MichaelL wrote

    All the talk about ‘picking the top quartile’ hedge funds is statistically nonsense, you don’t have enough data. Its guesswork not intelligence – thats the first thing to realise.

    Then if the people pushing hedge funds should learn a little bit about statistics. Then armed with this knowledge you’ll be able to see that , surprise, surprise, you’d be better off with a Vanguard tracker.

    The main market indexes always have outperformed the hedge funds indexes and always will.

  11. 28/01/2013, Rogerio wrote

    A lot of hedge funds do focus on wealth-creating companies using quite deep fundamental analysis to uncover undervalued businesses for their long book and overvalued ones for the short book.

    Yes, there are a lot of crummy hedge funds but there are also some great fund managers generating consitently better risk-adjusted performance than long only products.

    I think it’s quite clear the author lost money in a hedge fund or two and blames the entire industry. If he was a little better at selecting fund managers he might have a different opinion.

Commenting on this article closed

MoneyWeek magazine

Latest issue:

Magazine cover
Paying by mobile

Why your phone will replace your wallet

The UK's best-selling financial magazine. Take a FREE trial today.
Claim 4 FREE Issues
Shale gas 'fracking' promises to transform Britain's energy market. Find out what it is, what it means, and how to invest.

Which investment platform?

When it comes to buying shares and funds, there are several investment platforms and brokers to choose from. They all offer various fee structures to suit individual investing habits.
Find out which one is best for you.