Afterword

Having spent many years in the hedge fund industry, it’s been interesting to note the reaction of my peers as they learned I was writing this book. When confronted with the central theme, that hedge fund investors would have been better off in Treasury bills, few industry insiders are shocked. In fact, I’ve found people respond in one of two ways. Most are unsurprised because if you work in the hedge fund industry you don’t need to do the math that I’ve shown in this book to have an intuitive sense of how things have played out. More revealingly, a few others expressed genuine dismay that a tell-all book was being written. A cynic might conclude that this response reflected concern about highlighting past inequities and how this might upset a very comfortable business model. A more charitable conclusion is simply that nobody likes to see their industry trashed.

My hope is that this book will provoke a debate amongst investors, their advisers including funds of hedge funds, and hedge fund managers themselves. Not about the investment results though—there’s no point in debating the numbers. Selecting different indices to reflect hedge fund returns or different measures of assets under management (AUM) will produce outcomes that are different but not substantively so. When I first took the time in 2010 to calculate the industry’s internal rate of return (IRR) and saw my own intuition confirmed with the numerical results before me, I was amazed that nobody had done this before. Soon I came across the research paper written by Dichev and Yu (referred to in Chapter 1) which confirmed my own analysis in a thorough and robust fashion. Their results were already out in the public domain having been published in 2009, and yet few people seemed to have noticed. I found this incredible, and I contacted Ilia Dichev in 2010 to discuss his research. I thought his paper was a bombshell, a wake-up call to every hedge fund investor out there. The fact that it had received little attention probably reflected equanimity among those industry professionals who had read it. Just like the initial response of many insiders to the topic of this book, they weren’t surprised; even more reason for investors to take notice.

Ilia Dichev described the overall response to his paper as “moderate”. He speculated that it was because the message is “a bit of a downer”. While that’s probably true, I also think that since IRR is not widely used in analyzing hedge funds the enormous difference between traditionally calculated results based on average annual returns and the asset-weighted results that reflect how investors have really done are not readily apparent. Although few hedge fund professionals have expressed surprise to me at these results, most outside the industry are quite taken aback. I’ve discussed this with people who have a reasonably sophisticated knowledge of investing but are not directly involved in hedge funds, and like most of us they assume fabulously wealthy hedge fund managers are the result of similarly successful clients. This illustrates a huge misconception in popular opinion, and highlights the need for some changes. If this book serves as a catalyst for needed debate, it will have more than served its purpose.

The questions the industry should ask itself include:

These issues are worth examining, because it’s not as if hedge funds haven’t made money. They just haven’t passed those profits back to their investors. There’s no shortage of immense investment talent available, although there’s almost certainly too much capital in hedge funds today for the available opportunity set.

As with so many products in finance, part of the problem is that there’s no obvious business model to profit from a negative view (after all, it’s not easy to short hedge funds). There’s an entire industry, including hedge funds of funds, prime brokers, consultants, and others whose central purpose is to channel assets to hedge funds. And economies of scale dictate at every step that the larger funds will be favored. There’s little demand for consultants or advisers who profess skepticism, and no doubt those individuals who do simply make their careers elsewhere.

This book began as an essay in AR published in November 2010 (Hedge fund IRR has been pathetic). While the title was more biting than I might have chosen, it did draw attention and subsequent discussions convinced me I had a story that hadn’t yet been told. I started out believing the villains were the hedge fund managers and all the advisers who had channelled substantially too much capital to them. But my view shifted as I researched the book, and if there is a fault it lies squarely with many supposedly sophisticated investors who have applied far less critical analysis and cynicism to their allocation decisions. An industry has developed to meet demand, and the buyers have freely agreed to pay high prices for often mediocre results.

Saying hedge funds have been a bad investment for many should not be confused with saying they’re all bad, or that nobody has made money. There are many supremely talented hedge fund managers who have provided enormous value to their astute clients, and there are many highly successful clients of hedge funds. That will most likely always be the case. I know numerous people who are extremely happy with their investments. A hedge fund is the most lucrative asset-management business around and will continue to draw the very best talent. Some investors will always beat the averages, and demonstrate an ability to select high-decile managers before their returns deteriorate. But winning investors and value-providing hedge funds are not typical of the whole industry, and it’s doubtful that will change at anything like its current size.

The importance of manager selection was noted in Chapter 9. Since earning the average return on a hedge fund portfolio hasn’t beaten Treasury bills it’s safe to say that picking the right managers is indispensable for success. Average manager selection ability renders a hedge fund portfolio pointless. This should play well to allocators and consultants, since an important element of their value proposition is that they are good at picking tomorrow’s winners. Of course many of them are, but it’s worth noting just how difficult that is, and not just because we can’t all be above average.

Using the BarclayHedge database of hedge fund returns and AUM provides some measure of the challenge. Their database covers around a third of the industry by AUM, so it represents a fairly good sample. It includes more than 3,300 funds in total for whatever period of time they’ve reported, including many that have closed down. Like all hedge fund databases it suffers from the fact that managers report voluntarily, creating the survivor bias shortcoming in that poorly performing funds are generally not included and so returns in total are somewhat overstated. Analyzing the results beginning in 1994, if an investor could select funds that were at the sixtieth percentile or higher (i.e., better than 60 percent of all funds) he would have gained an additional 3.7 percent in annual performance compared with the asset-weighted average. This could be enough to make his hedge fund portfolio worthwhile. Only 40 percent of the industry by AUM is typically this good in any one year, but that’s still a sizeable selection to choose from.

However, the difficulty in selecting funds at the sixtieth percentile or higher is illustrated by the fact that funds routinely move in and out of the top tier of performance. In other words, there is limited persistence in good performance. Across the entire database for example, I found that for funds that were at the sixtieth percentile or better for any one year, they spent half of their existence below this level. On this basis a good fund may only be good every other year. Very few funds are consistently top performers. In fact, only 7 percent of the funds that were ever better than the sixtieth percentile managed to repeat that performance for every year of their lives. Far more common is for a relatively good year to be followed by a relatively poor year, and so on.

But hedge funds are not stocks. If your strategy is to buy the worst performing names in the S&P 500 every year and sell the best performers, it’s not very complicated to execute. Trading in and out of hedge funds annually is pretty much implausible. The due diligence is time consuming, redemption terms far less than the liquidity available in publicly traded equities, and many hedge fund managers would shun clients who tried to time their investments in this way. Hedge fund investments are intended to be held for years, and the infrequency of consistently strong performance makes it that much harder for any portfolio to contain mostly winners year after year.

At the time of writing (August 2011) the year is shaping up to be another challenging one for the industry. While this may appear to be driven by events outside anyone’s control (such as falling global equities), the central assertions of this book are that past performance for investors has been poor, and that future results will be no different without changes that include reducing the size of the industry. Since 2002, hedge funds have failed every year to beat a simple blend of 60 percent equities/40 percent high-grade bonds. Annual returns have slipped while AUM has risen, and at its current size hedge funds need to generate record trading profits every year to meet the fairly modest return expectations of their institutional client bases. This looks like a long shot. I look forward to watching events unfold.