Steer clear of troubled hedge funds

published 26 October 2012

The hedge-fund industry is under siege. Big names continue to quit the latest is Greg Coffey, the former chief investment officer of Moore Capital Management's European business. Meanwhile, Caxton Associates, known for running large, successful funds, joins a growing list of funds that are cutting their fees.

While we're often fans of investing in out-of-favour sectors, we wouldn't rush to pile money into this one. So, what's gone so badly wrong? Firstly, the emperor has been shown to be largely naked. Hedge funds used to be able to hide their colossal fees behind exotic-sounding investment techniques. But phrases such as short selling, quantitative analysis, high frequency trading and the like are now pretty commonplace. This has left hedge funds struggling to differentiate themselves, while added competition has made returns harder to come by and fees harder to justify.

In this tough environment, cutting fees makes sense. The problem is, they've got a long way to fall. One of the favourite charging structures, the 2 and 20' (a 2% annual management fee plus 20% of any performance over a chosen benchmark), is dying out. But not fast enough, given many other funds, such as investment trusts and exchange-traded funds (ETFs), charge lower annual management fees, often with no performance-linked element.

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That said, some investors might still be happy enough to pay for outperformanceif they were getting any. Yet given that "during the past ten years a portfolio of 60% US equities and 40% Treasuries outperformed hedge funds", as the FT's James Mackintosh notes, most investors have been sorely disappointed. Sure, some funds have done much better than others, but many of the best are closed to the retail market.

Worse still, in a bid to attract investors in the past, the hedge fund industry has been its own worst enemy when it comes to massaging up returns. Tricks include survivor bias' in the performance numbers this involves only including in the statistics the contribution of funds that survive and dropping those that don't. This might have seemed like a clever way to improve quoted performance in the bull market years some studies suggest it added 3%-5% annually to published performance figures but is hardly the way to win over fragile investor confidence in these much tougher times.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.