Have hedge funds lived up to the hype?

It all sounded so good: hedge funds would cost us more in fees yet always make higher returns than mutual funds. But are they just a complicated way of failing to beat the market? asks Merryn Somerset-Webb.

I'm quite sad about the state of the hedge-fund industry. When the hype started it all sounded so good. They would make absolute returns whatever the conditions in the market and their average returns would always be higher than those of mutual funds. They would cost us more in fees but it would be worth it.

What returns have hedge fund investors seen?

They have not lived up to the hype, though. A recent study by Roger Ibbotson and Peng Chan for Morningstar suggests that between 1994 and April this year the average hedge fund has returned a mere 9 per cent a year after fees. That's rather less than you would have made if you had just bought yourself a tracker on the US market: the S&P 500 index has managed an average return of 11.6 per cent over the same period.

More than 1,000 hedge funds have also closed over the past two years. Some have no doubt shut because their managers have made so much money they can't be bothered to work any more, but most haven't made any money at all.

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Are any hedge funds worth investing in?

Are there good hedge funds? Of course there are. Outperformance happens all the time. Some managers get lucky, others find that their methods work in particular market conditions at particular times and of course bull markets happen. In bull markets, funds that can borrow (which most hedge funds can) do better than those with no debt.

In general, though, hedge funds have turned out for the average individual investor at least to be a complicated way of making no more and often less money out of the equity markets than if they had stuck with a few index funds.

What about private equity?

I don't think hedge funds will long be alone in failing to live up to their hype. Next up is private equity, which has boomed in recent years. Money has been cheap to borrow, making it well worth borrowing piles of it, snapping up listed companies, taking them private, slashing their costs and then relisting them at a premium based on their improved cashflows.

But there are a few problems looming for this strategy. First, there isn't much left on the market for the giant funds to buy cheaply. Value investors (myself included) constantly complain that there is nothing left that is cheap enough to merit investing in. If value investors can't find value why should private-equity buyers? Second, fund managers are wising up. Not only do they no longer allow the companies they own to sell up to private-equity funds at overly low prices, but they don't seem so willing to buy the shares at a premium when they are relisted either.

Jeremy Lang, manager of the Liontrust First Growth Fund, points out that cashflows are always at their highest when private-equity funds sell companies back to stock market investors, but that they usually fall pretty quickly after listing. Why? Because having had not a penny spent on them during the cash-slash period, they have to play catch-up as soon as the private-equity men have taken their profits and skipped off.

What should your investment strategy be?

Private equity has had a good few years but with not much left to buy, and only a suspicious market into which to sell, one wonders if the next few will look anywhere near as good. Moreover, most studies show that after fees private-equity returns are much the same as ordinary stock-market returns. Private equity is, it turns out, a bit like the hedge-fund sector just another complicated way to not beat the market.

The final lesson from all this is the usual one. The more complicated an investment is, the less likely it is to deliver satisfactory results to average investors. So from now on perhaps we should make life a bit simpler. If you like the equity market, buy exchange-traded funds on the indexes you fancy. If you don't, don't. Simple as that.

First published in The Sunday Times 15/10/06

Merryn Somerset Webb

Merryn Somerset Webb started her career in Tokyo at public broadcaster NHK before becoming a Japanese equity broker at what was then Warburgs. She went on to work at SBC and UBS without moving from her desk in Kamiyacho (it was the age of mergers).

After five years in Japan she returned to work in the UK at Paribas. This soon became BNP Paribas. Again, no desk move was required. On leaving the City, Merryn helped The Week magazine with its City pages before becoming the launch editor of MoneyWeek in 2000 and taking on columns first in the Sunday Times and then in 2009 in the Financial Times

Twenty years on, MoneyWeek is the best-selling financial magazine in the UK. Merryn was its Editor in Chief until 2022. She is now a senior columnist at Bloomberg and host of the Merryn Talks Money podcast -  but still writes for Moneyweek monthly. 

Merryn is also is a non executive director of two investment trusts – BlackRock Throgmorton, and the Murray Income Investment Trust.