The Utter Ordinariness Of Hedge Funds

January 31, 2008

What strikes me about hedge funds, Murray, is not that they are good or bad; it's that they are so boring.

I've read the debates about whether or not hedge funds beat market averages. Mostly, the studies are not helpful. Whether you believe Burton Malkiel's assertion that hedge funds lag the S&P 500 or not, it's beside the point. Hedge funds don't invest in U.S. large-cap stocks; they invest internationally, use derivatives and follow a wide range of strategies.

Despite the reputation and the occasional blowup, hedge fund returns are actually pretty dull. The higher-risk strategies like emerging markets produce high returns with high volatility, while lower-risk strategies like merger arbitrage produce lower returns with less volatility. That and $2 will get you on the subway.

My guess is that hedge funds lag the global capital markets by their costs, on average. There's nothing inherently wrong with the hedge fund structure. The fact that funds have some control over capital flows is probably a slight advantage over mutual funds; the lack of transparency is probably a disadvantage. I even like incentivizing fund managers.

The big problem with hedge funds is that their costs are so high. 2 and 20? Hah. And the incentives only work on one side: If the funds go up, the managers get paid extra; if the fund goes down, nothing happens. (One of the best things about Vanguard's actively managed funds is that they penalize managers who trail their benchmarks.)

Of course, the best hedge funds are also closed to new investors.

Really, beyond costs, there's nothing wrong with hedge funds. I actually like the way they exist on different spots of the efficient frontier, and some of the new hedge fund replication strategies (both mechanical and synthetic) are interesting.

But does it make sense to pay 2 & 20 for the funds? You gotta be kidding me.

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