The Hedge Fund Myth – July 2007

July 24, 2007

Dow Jones Average: 13,943
S & P 500 Index: 1,542


The Hedge Fund Myth

The investing public has a glamorized view of hedge funds. It is widely believed that these investment pools are run by some of the savviest investment managers and routinely outperform the typical manager or mutual fund. The reality is something quite different. Recent studies of hedge fund performance show that on average they badly trailed the market averages for the period 1995-2003, largely due to the extraordinarily high fees extracted by the hedge fund managers. In his 2006 letter to shareholders, Warren Buffett called the fee structure levied by hedge funds a “grotesque arrangement” between manager and client. In spite of the warnings and negative results, money continues to pour into hedge funds from public pension plans, endowments, and other investors who meet the legal qualifications to be partners in the funds.

The first hedge fund was formed in 1949 by Alfred Winslow Jones, a writer for Fortune magazine, who wanted to guard against another big drop in the stock market. The earliest hedge funds held some positions that were poised to benefit from a market rise, and other positions that were likely to gain value in a falling market. The funds were designed to be less volatile than an ordinary portfolio, making less in an up market and losing less during periods of market decline. While some modern day hedge funds follow a similar strategy of hedging their bets, many others use leverage (borrowed money) and high risk strategies in an attempt to boost returns and make the high fees palatable.

There is a mystique surrounding hedge funds, in part due to the well advertised success of people such as George Soros, the legendary investor who made more than a billion dollars for his hedge fund by shorting the British pound. Such stories hold great allure for those looking to be part of something grand, something mysterious, and possibly highly profitable. But for every George Soros there are hundreds of ordinary hedge fund managers who are not as bright, do not have nerves of steel or great timing, and in no way justify the exorbitant fees that they charge.

In any endeavor that involves risk and probabilities there will be some highly visible winners and many forgotten losers. Investors in hedge funds are willing to endure high fees in the hopes of outsized gains, but are more likely to end up with inferior returns. The mathematics of the arrangement works inexorably against the investors. The typical hedge fund fee is two percent of assets under management plus twenty percent of any profit made for a given year. The payment of such high fees turns a 12 percent return prior to fees into an eight percent return after fees. Hedge funds as a group would have to outperform the market indices by gigantic amounts every year to end up outperforming after fees are levied. The law of averages holds that a few firms may do well enough to justify the fees, but that most will earn an average return before fees and under perform after fees.

The one certainty is that hedge fund managers outperform just about everyone when it comes to their own salaries. As a group they are the highest paid people on the planet. One or two good years at a medium size hedge fund can produce fees that set the managers up for life. Hedge fund compensation agreements are a one way street, the firms receive a big share of their clients’ profits in good years but do not share in the losses after bad years. One has to wonder about the ethics of a financial arrangement that works so well for one party and so poorly on average for the other.

The hedge fund industry has mushroomed in recent years and has increasing impact on the financial markets. A major hedge fund, Long Term Capital, became insolvent in 1998 which contributed to a sharp slide in the market indices that summer. There are now thousands of new, highly leveraged hedge funds run by relatively inexperienced managers. The government has expressed worries about the trillions of dollars in debt and obligations taken on by hedge funds, but so far has done nothing to rein in this unregulated, unfettered industry.

Hedge funds are no longer hedged as much as they are leveraged. The leverage is used to boost the return on otherwise mediocre investment choices. Of course leverage works both ways, exaggerating small losses as well as small gains. With enough leverage at work even a minor mistake can result in a huge loss. Recent declines in the value of sub-prime mortgages quickly wiped out all the value (billions of dollars) in two hedge funds run by Bear Stearns. The borrowings taken on by hedge funds have fueled some of the recent gains in the stock market. At some point the unwinding of leveraged positions will have the opposite effect, accelerating a market decline. It would be less of a concern if hedge funds could simply be dismissed as the equivalent of casinos for aggressive investors, but their potential impact on other investors is too large to ignore.

Current Strategy

After stumbling in the first quarter of 2007, equity markets around the world marched higher in the second quarter. Worries about mortgage defaults, higher inflation, and rising oil prices were trumped by a flood of merger and acquisition announcements. The logic of buying out companies at record price levels in a hot market eludes us, but the private equity, merger and acquisition (M &A) firms seem to have an appetite for just about any company at this time. We wonder why the buyout binge is occurring at this elevated market level. Acquisitions could have been made five years ago, three years ago, or just one year ago at substantially lower prices. The only explanation is that the M&A firms are being flooded by investor money and feel that they have to commit the funds to some kind of a deal. The merger and buyout activity of today reminds us a lot of the buying in 1999-2000.

We stand aside when other investors are stampeding into stocks. The high prices for most equities mean that very few stocks now score well on our proprietary stock evaluation scale. Sometimes the market gives investors a buying opportunity and sometimes it provides a great moment to take gains. We feel strongly that this is a time to take profits on positions we purchased for clients in prior years when prices were much lower. We do not know when the next major buying opportunity will come, but we know that every high market has been followed by a period of severe retrenchment. Markets that are as pumped up as this one often charge right over a precipice.

Our strategy for fixed income investments is relatively unchanged from last quarter. We are content to hold shorter term treasuries yielding about five percent, inflation protected securities that provide a similar total return, and tax-exempt municipal paper yielding over 4.25 percent. The future direction of interest rates is extremely hard to predict at this time. Rates could fall if a serious economic slowdown afflicts the U.S. economy, or they could rise due to higher inflation, a lower U.S. Dollar, and economic strength abroad. Given the unknowns, we are sticking with a flexible, shorter term strategy that reliably produces five percent on our clients’ fixed income investments.

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