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Are Hedge Funds Worthwhile Investments?

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We don't need a lot of analysis to guess that the average investor shouldn't be in hedge funds. The relevant question is, should any investor be in hedge funds?

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I just finished reading The Hedge Fund Mirage, by Simon Lack. I'm not planning to review it here, but it did get me thinking about a subject that's trickier than it seems: how to measure investment performance.

Simon Lack ran a business for a few years for JPMorganChase (JPM), investing in start-up hedge funds. In a typical deal, he would invest $25 million in a new hedge fund in return for 25% of the fees collected by the manager on all contributions from all investors. The appeal to the fund manager was that $25 million was enough for the fund to be taken seriously so that if it put together a good track record, it could grow into a sizeable business.

What Lack noticed after a while is the return on the investments in the hedge funds themselves was smaller than the amount received from the fee splitting. This led him to suspect hedge funds were more profitable for the managers than for the investors. He further noticed that there are a lot of billionaire hedge fund managers, but it's harder to think of people who made their billions by investing in hedge funds.

Digging a bit deeper, these are not great arguments. Lack chose hedge funds likely to have rapid fee increases, and by his own admission was shut out of the best funds (to be fair, his selection process probably weeded out the worst funds too). The funds would self-select; giving away 25% of your revenue in order to increase your visibility means you are a fund that values growth over profitability. And, of course, Lack was paid off the top. Any business looks great if you only get the revenue, not the expenses.

The point about rich hedge fund managers could be made about any business. People get rich starting insurance companies; no non-felon gets rich buying insurance. Even in investment management, you could make $100 each for 100 million people, $10 billion total economic value, and make $1 billion yourself. Ten percent seems like a reasonable fee, but you still did much better than any of your customers. Finally, three quarters of the money in hedge funds come from institutions, and there are certainly institutions that have made billions from hedge fund investments.

But Lack didn't stop with anecdotes. He studied the numbers and came up with a claim that garnered him a lot of news coverage: The average hedge fund investor between 1998 and 2010 would have done better in Treasury bills. There are some problems with this statement. The numbers shown in the book demonstrate hedge funds doing considerably better than Treasury bills. The paper that is referenced is Dichev and Yu, "Higher Risk, Lower Returns: What Hedge Fund Investors Really Earn." That paper's abstract states hedge fund returns "are only marginally higher than the risk-free rate as of the end of 2008." That's higher, not lower. And the study ends after 2008, the worst year by far. Investors recovered quite a bit in 2009 and 2010.

Even with those qualifications, the paper sounds bad for hedge funds. However, there's more to the story. First, the paper is based on returns that some funds report voluntarily to hedge fund databases. There are well-known problems with those data sets. Second, it ignores what is supposed to be the major purpose of many hedge funds: providing uncorrelated returns. A hedge fund can deliver low, or even negative, returns and still improve the risk-adjusted return of an investor's portfolio. Most hedge funds are not designed to be stand-alone investments-they provide either exposure to specific risks or diversification benefits. But neither of those arguments demonstrates that hedge funds are good investments, they merely say we can't put too much weight on the data either way.

So let's go a bit further. There are two obvious ways to measure the overall performance of hedge funds. You could ask, "What happened to an investor who put $1 in every hedge fund at inception?" This method is known as "time-weighted returns"; it is the kind you most often see quoted. It turns out that the Dichev and Yu data show that investor did quite well, even if she pulled all of her money out at the end of 2008; far better than investing in T-bills (or stocks, which did worse than T-bills over the period).

The second obvious question is, "What happened to an investor who invested in hedge funds in the same proportion as other investors?" That is, if investors put $10 million in hedge fund A in month B, our hypothetical investor put in a fixed fraction of that, say $10. If investors put $30 million in fund C in month D, our investor contributed $30. These are known as dollar-weighted returns. Well, Dichev and Yu showed these investors did well too -- about as well as the time-weighted investors.

So who was the hypothetical investor who did only a little better than T-bills? It turns out there isn't one. The computation that gets that result takes the dollar-weighted returns for each fund and averages them. That may sound reasonable at first glance, but it's not. Averaging over funds means our hypothetical investor would have to put the same dollar amount in each fund. But dollar-weighting the returns in each fund means our investor has to contribute his dollar in the same proportion as other investors in the fund. So if a fund is a flop and never gets another subscription after opening, our investor puts his dollar in at inception. But if a fund is a huge success and attracts lots of additional subscriptions, our investor puts only a tiny amount in at the beginning; almost all of his investment will be after the good performance that made the fund successful. The scheme is impossible to implement, an investor would have to know the future investment flows of each fund in order to determine how much to invest. And if the system were possible, it would be perverse, a strategy designed to lose money. If you did know the future flows, you would put all your money in the funds that were going to grow before they grew -- the exact opposite of the Dichev and Yu strategy.

Again, none of this proves hedge funds are good investments for the average investor. Actual investor experience tends to be measurably worse than simple averages from hedge fund databases would suggest. Another attempt to get at this question is Aiken, Clifford and Ellis, "Out of the Dark: Hedge Fund Reporting Biases and Commercial Databases." These authors look at hedge fund returns from fund-of-funds, which has the advantage of reflecting actual investor experience rather than self-reports. Unfortunately, that has problems as well; it does not provide a good sample of all hedge funds. Still, I think it's more reliable than the databases.

I think a better approach is to look at the performance of institutional investors who use hedge funds versus those that do not. A good example is Lerner, Schoar and Wang, "Secrets of the Academy: The Drivers of University Endowment Success." Like the fund-of-funds study, this is based on real investment returns, and it has two additional advantages: (1) The data are public so everyone agrees on the numbers and the arguments are only about investment theory; (2) it evaluates hedge funds by their contribution to portfolios rather than stand-alone.

Unfortunately, it has a disadvantage as well: it covers only hedge funds selected by large institutions. In fact, the authors conclude that while hedge funds do a lot of net good for sophisticated institutions, much of that benefit comes from the institution's skill in fund selection and ability to negotiate for good terms. Therefore the results cannot be applied to the average hedge fund investor.

When data fail, we still have common sense. We know there are a lot of bad hedge funds. Some charge too much, some provide only the same beta exposure you can get with an index fund, some abuse their investors, and a few are out-and-out frauds. Of course, there are bad public mutual fund managers as well, with the same faults. But it is possible for any investor, even the least sophisticated, to find high-quality, low-cost, tax-efficient index funds and lock in average performance -- above-average performance after fees and taxes. So any active investment only makes sense if you think you can avoid the bad managers, and that the cost of the search is less than the extra return you can get as a result. You should also consider that the average person who thinks he can pick superior managers is wrong. We don't need a lot of analysis to guess that the average investor shouldn't be in hedge funds. The relevant question is, should any investor be in hedge funds?

I happen to think the answer to that last question is "yes," but I don't claim to have definitive proof. I wouldn't even bother to argue with anyone who feels differently. At this point it's a matter of opinion; you can find reasonable theory and data to argue either way. So put your money where you think best, and beware of anyone who claims to be sure that they know better.
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