Hedging your bets supposedly protects against catastrophic losses. But when the 2008 recession hit, many investors in hedge funds lost heavily. The worldwide collapse in credit and in asset prices was worse than any downturn since the Great Depression. Housing prices tumbled, the S&P 500 fell 57 percent from its October 9, 2007, high, and US private wealth declined from $64 trillion to $51 trillion. Small investors like my niece and my house cleaner, watching the equity index funds in their IRAs plunge, asked me if they should dump their stocks. Many investors had to sell, including the wealthiest university endowment fund in the country, Harvard’s, valued at $36.9 billion in early 2008 but now desperate for cash.
Hedge funds, which were supposed to protect investors against such declines, dropped an average 18 percent. Even so, the most highly compensated hedge fund manager, James Simons of Renaissance Technologies, made $2.5 billion. The top twenty-five managers collected $11.6 billion, down from $22.5 billion in 2007.
It was now twenty years after the end of Princeton Newport Partners, and hedge funds had proliferated until there were ten thousand worldwide, with total equity estimated at $2 trillion. Their worldwide pool of wealthy investors is a mix of private individuals, trusts, corporations, pension and profit-sharing plans, foundations, and endowments. The 2008 crash dealt a massive blow to the hedge fund industry. Four hundred billion had been swept away. This triggered worldwide requests for withdrawals by investors who were angered by losses that weren’t supposed to happen. They were shocked when many funds refused to return their remaining money.
As the economy slowly recovered and the market bounced back to new highs, investors forgot what happened to them in 2008–09. By 2015 hedge fund assets reached a new high of $2.9 trillion. Management fees ranging between 1.5 and 2 percent delivered $50 billion to the operators. Their percentage of the profits added perhaps another $50 billion. This $50 billion in performance fees supposedly represents 20 percent of the profits after all other charges. But investors as a group actually pay a larger percentage. To see why, suppose there are two funds that start the year at $1 billion each. One fund nets $300 million and the other loses $100 million. At 20 percent of profits, the first fund collects a $60 million performance fee and the second collects none. Pooling the results from the two funds, we see that investors pay $60 million on a profit of $200 million, a rate of 30 percent of the combined gains and losses.
With Princeton Newport, growth from new capital came slowly and was earned by performance. Over forty years this battle for funding changed dramatically. So-called alternative investments became the hottest new frontier for what to do with your money. Beginning in the late 1990s, you could, in effect, just put up a sign saying HEDGE FUND OPENING HERE, and a line of investors would quickly extend around the block. A modest-sized $100 million hedge fund earning a gross return of 10 percent per year ($10 million) may pay the manager or general partner a management fee of 1 percent of $100 million—$1 million. In addition, the manager gets 20 percent of the remaining $9 million in profit, or another $1.8 million, as a performance fee, for a total of $2.8 million per year. Some of this, perhaps $1 million, pays expenses, leaving a net of $1.8 million a year in pretax income. The investors, or limited partners, get the remaining $7.2 million for a 7.2 percent annual return.
The general partners in a similar billion-dollar hedge fund—and there are scores of them—might share ten times as much, or $28 million a year. Even a little $10 million hedge fund would, with proportionate fees, expenses, and returns, provide a single general partner with $280,000 a year. It’s clear from this that you can get very rich running a hedge fund. With these rewards, we shouldn’t be surprised to find many of the (believed to be) best investors in the business running hedge funds.
The consensus of industry studies of hedge fund returns to investors seems to be that, considering the level of risk, hedge funds on average once gave their investors extra return, but this has faded as the industry expanded. Later analyses say average results are worse than portrayed. Funds voluntarily report their results to the industry databases. Winners tend to participate much more than losers. One study showed that this doubled the reported average annual return for funds as a group from an actual 6.3 percent during 1996–2014 to a supposed 12.6 percent.
The study goes on to point out that if returns over the years are given weights that correspond to the dollars invested, then the returns are “only marginally higher than risk-free [US Treasury Bonds] rates of return.” Another reason that reports by the industry look better than what investors experienced is that they combine higher-percentage returns from the earlier years, when the total invested in hedge funds was smaller, with the lower-percentage returns later, when they managed much more money.
It’s difficult to get an edge picking stocks. Hedge funds are little businesses just like companies that trade on the exchanges. Should one be any better at picking hedge funds than we are at picking stocks?
Hedge fund investors also suffer major disasters. In the spring of 2000, after severe losses, one of the biggest collections of hedge funds in the world, run by Julian Robertson, which included the flagship Tiger Fund, announced that it was closing. From small beginnings in 1980, Robertson’s funds had grown to $22 billion before the demise. At the end, a combination of market losses and investor withdrawals chopped the pool to $7 billion, with more withdrawals pending. Robertson, claiming to be a value investor, blamed irrational crazed high-tech markets. As Shakespeare might advise, “The fault is not in our markets, but in ourselves…”
A couple of months later, another of the world’s biggest hedge fund groups, managed by George Soros and associates, including his flagship Quantum Fund, announced heavy losses, followed by withdrawal of most investor funds. Drastically downsized from a peak of over $20 billion, Soros’s operation was restructured and converted into a vehicle to manage his own money. Soros and his principal associate, Stanley Druckenmiller, had taken the opposite posture to Robertson: They had bet on tech stocks. At about the same time, Van Hedge Fund Advisors, in an article titled “Good Year for Hedge Funds,” announced that the preceding year, 1999, was the best year for their hedge fund index since they began it in 1988: +40.6 percent in the United States and +37.6 percent offshore. Soros later resurged. In 2008 he personally made $1.1 billion, an amount that was good for only fourth place among hedge fund managers that year.
Should you invest in hedge funds? First you need to determine if you’re economically qualified. Though such funds typically require a minimum investment of $250,000 or more, some start-ups will relax this to $50,000 or $100,000 when they first raise money. The original reason to require a substantial minimum investment was historical. In order to qualify for certain exemptions from securities regulations, and thereby gain the freedom to make a wide range of investments, hedge funds had to limit themselves to fewer than one hundred partners. But then, in order to have a pool of tens or hundreds of millions of dollars, the fund had to avoid filling their quota of partners with small investors.
The SEC later raised the limit to five hundred partners in certain circumstances. Many hedge funds only admit accredited investors; in the case of individuals, that means those who jointly with their spouse have a net worth of at least $1 million or have had an income of at least $200,000 in each of the last two years and expect to repeat that figure in the current year. This leaves plenty of candidates. In 2013, among more than one hundred million US households, the number having a net worth of $1 million or more was estimated at between five and eight million.
Next you need to determine whether either you, or an agent you choose to act for you, are knowledgeable enough. As the $65 billion Ponzi scheme perpetrated by Bernard Madoff showed, thirteen thousand investors and their advisers didn’t do elementary due diligence because they thought the other investors must have done it. The issue here is the same as for those buying stocks, bonds, or mutual funds. You need to know enough to make a convincing, reasoned case for why your proposed investment is better than standard passive investments such as stock or bond index funds. Using this test, it is likely you will rarely find investments that qualify as superior to the indexes.
Another issue is taxes. US domestic hedge funds, like most active investment programs, are tax-inefficient. Their high turnover tends to produce short-term capital gains and losses taxed at a higher rate than securities owned for more than one year.
For tax-exempt investors, US hedge funds that borrow money (but not their clones based outside the United States) trigger taxes for the otherwise tax-exempt entity to the extent the realized gains, losses, and income are generated by the loans. This is called unrelated business taxable income (UBTI).
If you have an area of expertise, look for funds that your knowledge can help you evaluate. Hedge fund data services typically list more than a thousand or so funds from the several thousand that currently exist. These services, along with Internet sources like Wikipedia, classify hedge funds by asset types. Another way to sort is by methodology, such as: fundamental, using economic data as opposed to technical, using just price and volume data; or quantitative (using computers and algorithms) compared with non-quantitative; or bottom-up (analyzing individual companies) versus top-down (focusing on broader economic variables). Other important characteristics are the fund’s expected returns, risks, and how the payoffs correlate with those from other asset classes. For instance, the returns from funds that exploit trends in the prices of commodity futures often are not correlated significantly with the market. This can make them useful in reducing the fluctuations in the value of your overall portfolio. There are equity long-only funds, short-only funds, and long/short funds. Market-neutral funds (like PNP and Ridgeline) attempt to have returns uncorrelated with the market.
Funds also may specialize by geographic area or by a country’s level of financial and economic development such as so-called emerging markets, or by economic sector such as biotechnology, gold, oil, or real estate.
You can also choose a “fund of funds,” which is a hedge fund that invests in a portfolio of other hedge funds—much the way mutual funds invest in a collection of stocks—and whose management is in the business of evaluating hedge funds. In addition to what the hedge funds charge directly, the fund of funds manager collects a second layer of fees, typically 1 percent per year plus 10 percent of the profits.
A class of people as smart as hedge fund managers can hardly be expected to overlook the advantages of deception. In fact, hedge funds frequently start out small and build spectacular records, later turning ordinary as they grow.
One method that leads to this has also been used to launch new mutual funds. Fund managers sometimes start a new fund with a small amount of capital. They then stuff it with hot IPOs (initial public offerings) that brokers give them as a reward for the large volume of business they have been doing through their established funds. During this process of “salting the mine,” the fund is closed to the public. When it establishes a stellar track record, it is opened to everyone. Attracted by the amazing track record, the public rushes in, giving the fund managers a huge capital base from which they reap large fees. The brokers who supplied the hot IPOs are rewarded by a flood of additional business from the triumphant managers of the new fund. The available volume of hot IPOs is too small to help returns much once the fund gets big, so the track record declines to mediocrity. However, the fund promoters can use more hot IPOs to incubate yet another spectacularly performing new fund; and so it goes on.
The SEC finally acted in 1999, when for the first time it brought about the firing of one well-known fund manager for playing this game. The manager’s growth fund, best in its category for 1996 but closed to the public, reportedly had only a few hundred thousand dollars in capital at that point and got more than half its first-year gain of 62 percent from thirty-one hot IPOs! The manager opened the fund to the public in February 1997, to a flood of money, but failed to disclose the use of IPOs to inflate the track record.
Of course there are many reasons, other than salting the mine, for a decline to mediocrity. For a manager to get major investor attention he typically needs a decent initial record, or a persuasive case based on factors like a prior reputation, or even a business plan. Sometimes, just simple sales hype is enough. Some managers are lucky when they start—perhaps starting a “growth fund” in the late 1990s and buying a few Internet stocks like AOL or Amazon.com. With time, lucky managers tend to fade.
Hedge fund operators have ways of ending up with far more than the 20 percent of profits typically specified as their management fee. One of these I call “Heads we win, tails you lose.” To see how this works, go back to 1986 when I was interviewing a wealthy hedge fund manager to see if my fund of hedge funds, OSM Partners, should invest with him. Times were good, his flock of hedge funds were prospering, and he invited me to leave PNP, bring my expertise and employees, and join him. I’d get half the management fee on a much larger pool of money. No, thanks.
The following year the crash of October 1987 hit his funds with losses varying from 30 percent to 70 percent. Performance fees would not be paid to him again until these losses were recovered. It might take years. If he’s down 50 percent, for example, he has to double the money, making 100 percent, just to get even again. Facing no performance fees for years, he chose to terminate his hedge funds, leaving himself rich and his investors with losses. The net result was that he made off with all the profits. In less than a year he launched a fresh set of hedge funds, from which he could have the chance to immediately collect performance fees.
Cherry-picking, as I call it, is another way some hedge fund managers milk their limited partners. I first came across this in the late 1970s. It was a lackluster decade for equities. A guru had been picking undervalued companies and making 20 percent or so per year before his fee. After friends recommended I invest, I did some digging and learned he had another pool that was making 40 percent. That was just for himself, his family, and close friends. That pool got its fill of the best situations. The rest went to the 20 percenters. I don’t invest with bad people, so I passed. Hedge fund documents, drawn up by lawyers hired and instructed by the general partner, typically permit these conflicts of interest.
Improperly charging expenses to the partnership is another way that the limited partners get less than they should. The list of issues goes on, the point being that hedge fund investors don’t have much protection and that the most important single thing to check before investing is the honesty, ethics, and character of the operators.
The hedge fund Long-Term Capital Management was launched in 1994 with a dream team of sixteen general partners, led by the legendary former Salomon Brothers trader John Meriwether and two future (1997) Nobel Prize winners in economics, Robert Merton and Myron Scholes. The group included other former Salomon traders, more distinguished academics, and a former Federal Reserve vice chairman. Investors included the central banks of eight countries, plus major brokerages, banks, and other institutions.
The principals of a financial engineering group I knew, who were coincidentally doing work for LTCM at that time, asked if I had an interest in investing in the fund. I declined because Meriwether had a history at Salomon of being a major risk taker and the partnership’s theorists were, I believed, lacking in “street smarts” and practical investment experience. Warren Buffett says, “Only swing at the fat pitches.” This did not look to me like a fat pitch.
The annual percentage return to LTCM investors was in the 30s and 40s, but this was based on enormous leverage, reportedly varying between 30:1 and 100:1. Without leverage, returns would be just a fraction of a percent over the cost of money. They had hundreds of billions long and hundreds of billions short. They expanded to $7 billion in capital before giving back $2.7 billion, which increased both the risk and the return on the remaining capital. Later, when adverse market conditions created fairly small losses in percentage terms, the leverage magnified the impact and nearly wiped them out. After losing 90 percent of their capital in weeks, and with total ruin imminent, the fact that they were “too big to fail” led to a rescue effort encouraged by the Federal Reserve. The fund was liquidated in an orderly fashion and investors recovered a small percentage of their stake.
Not long after, Meriwether and four others of the sixteen partners started a new hedge fund similar to LTCM, but using less leverage. Nobelists Scholes and Merton chose not to join him again. Investors, including some of the losers from LTCM, soon put up $350 million. Growth and new capital increased it further. Then his “flagship” fund was reported to have ended the year 2008 down 42 percent, losing more than $300 million. It closed in 2009. In 2010 Meriwether started yet another hedge fund. Merton became a consultant to J. P. Morgan & Co., while retaining his teaching position at Harvard. Scholes returned to his faculty position at Stanford, became a financial consultant, and later launched another hedge fund.
The lessons we should have learned about excess leverage from the collapse of Long-Term Capital Management were ignored. Ten years later, history repeated on a worldwide scale when loose regulation and high leverage led to the near-collapse of the entire financial system in 2008. As part of the overall meltdown, hedge fund assets fell from $2 trillion to $1.4 trillion from losses and withdrawal of capital. Hedge funds were now a mature asset class. I predicted to The Wall Street Journal that any edge for investors would gradually disappear.
Meanwhile, the superrich, buttressed with government bailout billions, bounced back from the Great Recession. By 2012 they were richer than ever.