Swedroe: Even Stars Knock Hedge Funds

If you don’t believe Swedroe Snark about hedge funds, perhaps critical comments from other investment industry luminaries will stick.

This blog is the second part of a three-part series this week on problems with hedge funds and private equity—how they’re viewed and how they affect financial markets as a whole. The first part was titled “Nails In The Hedge Fund Coffin."

Investors tend to think of hedge fund managers as the superstars of the financial world. Collectively, it’s estimated they now manage somewhere in the neighborhood of $3 trillion. Unfortunately, their reputation hasn’t translated into the type of returns that live up to all the hype.

As we’ve continued to demonstrate over the years, the hedge fund industry has had a hard time keeping up. In fact, over the last 10 calendar years, 2004-2013, the HFRX Global Hedge Fund Index underperformed every single major domestic and international equity asset class. It even managed to underperform one-year Treasury notes, let alone longer-term Treasurys.

Despite this abysmal performance, marketing hype and hope is triumphing over wisdom and experience. Money continues to pour into hedge funds. It just goes to prove Abraham Lincoln’s belief that you can indeed fool some of the people all the time.

Regular readers of my books and blogs know that one of my favorite hobbies is collecting epigrams with words of wisdom for investors. Earlier this week, we discussed the negative consequences of hedge fund use in pension plans, and I thought I’d continue with the hedge fund theme. The following are some of my favorite thoughts about hedge funds.

The first comes from Cliff Asness, one of the founders of Connecticut-based AQR Capital Management. His firm happens to run hedge funds as well as mutual funds. This is his definition of the industry:

“Hedge funds are investment pools that are relatively unconstrained in what they do. They are relatively unregulated (for now), charge very high fees, will not necessarily give you your money back when you want it, and will generally not tell you what they do. They are supposed to make money all the time, and when they fail at this, their investors redeem and go to someone else who has recently been making money. Every three or four years they deliver a one-in-a-hundred year flood. They are generally run for rich people in Geneva, Switzerland, by rich people in Greenwich, Connecticut.”

The next bit of wisdom comes from David Swensen, chief investment officer of Yale University. He writes in his book, “Unconventional Success: A Fundamental Approach to Personal Investment”:

“In the hedge fund world, superior active management constitutes a rare commodity. Assuming that active managers of hedge funds achieve success levels similar to active managers of traditional marketable securities, investors in hedge funds face dramatically higher levels of prospective failure due to the materially higher levels of prospective failure due to the materially higher levels of fees.”

And in an article appearing in The Economist, Swensen had this to say about the fund of hedge funds:

“Fund of [hedge] funds are a cancer on the institutional-investor world. They facilitate the flow of ignorant capital.”

Stephen Brown, a professor at NYU’s Stern School of Business, has published numerous research papers on the hedge fund industry. He told BusinessWeek:

“Half of [ex-mutual fund managers] that become hedge fund managers and survive the first six months are dead two years later.”

Next up is one of my personal favorites. It comes from Professor of Finance and Nobel Laureate Eugene Fama:

“If you want to invest in something (hedge funds) where they steal your money and don’t tell you what they’re doing, be my guest.”

And finally, we have these words of caution from Gary Weiss, author of “Wall Street Versus America”:

“Hedge funds are the only component of Wall Street that is built pretty much entirely upon myth. Few areas of financial endeavor have been a subject of so many hoary myths, moronic half-truths, goofy speculation, once-true falsehoods, and knucklehead fantasies.

Weiss also warned:

“Usually the financial press forgets to mention that the superstar investors tended to make their biggest bucks when they were managing small sums of money. Some of the biggest names in the business liquidated or wound down their funds when their assets swelled beyond reasonable size, the odds caught up with them, and their performance turned lousy.”

Weiss addressed some of the things that hedge funds do for you, the investor. He offered this list:

• They cause people to pay fees that would be considered highway robbery in even the most wack-a-doo mutual fund.
• They cause people to buy into “black box”—give me the money and I do what I want with it—investment strategies.
• They cause people to give their money to creeps they haven’t bothered to check out, the kind of people they wouldn’t trust to run out and buy them a sandwich, much less manage their fortune.
• They cause people to sign contracts that are so one-sided they would make a credit-card lawyer blanch, including “lock up” clauses that keep their money confined to their funds for as many years as some fund managers should be confined to prison.
• They cause people to agree, sometimes eagerly, to be treated like slightly retarded schoolchildren and not be given any information about what is being done with their money.
• They cause people to buy investments products that are functionally equivalent to mutual funds, except they overcharge you and give you the ability to tell your golf buddies that you’ve invested in a hedge fund.

Weiss then concluded with the following:

In return they provide performance that is subpar, inconsistent, not worth all the risk, or all of the above.

I really couldn’t have said it better myself. Of course, not everyone heeds this sage advice. Sometimes not even the smartest guys in the world.

The Nobel Prize, a set of annual international awards bestowed in a number of categories in recognition of cultural and scientific advances, was established through the will of the Swedish philanthropist inventor Alfred Nobel. Each year, the Nobel Foundation decides on the amount of the award given to each prize winner. Because of years of low returns, the foundation was forced to cut the size of its cash prizes in 2012.

The Nobel Prize is one of the most prestigious awards one can receive—which is why it came as a shock when the foundation announced that, in light of the poor performance of its investments, it now plans to increase investments in hedge funds.

What are these people thinking? Are they completely unaware that the returns to hedge funds have been abysmal? With the sole exception of 2008, the HFRX Global Hedge Fund Index underperformed the S&P 500 Index in each of the last 10 calendar years—which brings to mind that adage about even blind squirrels occasionally finding acorns.

Perhaps there was a time when hedge funds were able to deliver alpha—when the industry was much smaller and the investment strategies they typically pursue was less “crowded.” However, the evidence is very clear that time is long gone. While there will always be some hedge funds that will deliver outperformance, there is no evidence that investors are able to identify them ahead of time.

All in all, the decision by the Nobel Foundation can only leave one scratching their head.

Next, we’ll examine the relationship between hedge funds and the market, specifically their impact on returns, liquidity and volatility.

Larry Swedroe is the director of research for the BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.