The Great Hedge Fund Mystery

If you’ve heard people are making a killing in hedge funds, you heard right. The operators of hedge funds earn oversized fees year in and year out. Their investors, not so much.  What do the hedgies do to earn the big fees? This is one of investing’s most baffling mysteries.

Hedge funds are essentially mutual funds without a curfew. Because they can only be sold to “sophisticated investors,” hedge funds have more latitude to use leverage, sell securities short, and make other kinds of bets that are not available to their more tightly regulated investment kin.

At what price mediocrity?

There’s also a big pricing difference. Hedge fund managers charge a stiff management fee each year. Two percent is the norm.  In addition, they take a share of profits in any year when they produce a positive return. Twenty percent is the norm, and the take can run as high as fifty per cent. They do not pay a penalty for a negative return.  By comparison, an actively managed mutual fund might charge .8 to 1.5 percent annually. Meanwhile most index ETFs, our vehicle of choice, charge 5-25 basis points, or even less.

So for these high fees, what do investors get? As recent articles describe, they get pretty humdrum performance and a lot of mystery. In his New Yorker piece, John Rich writes that hedge funds have delivered approximately the return of the S&P 500 since 1994.

Rich debunks the idea that hedge funds outperform the markets, as well as other often heard assertions, such as their better risk-adjusted or uncorrelated returns. Ultimately his article, ‘How Do Hedge Funds Get Away With It?’ and Noah Smith’s Bloomberg piece, ‘Hedge Funds Won’t Make You Rich’ point to perception – or misperception, perhaps – as the prime justification for premium fees.

Better an owner than an investor

The arithmetic of hedge fund returns overwhelmingly favors the owner-operators.  Hedgies can make a lot of money for themselves.  How much?  The 25 highest paid hedge fund moguls took home $21 billion for themselves in 2013. David Tepper led the pack with $3.5 billion.  Steve Cohen came in second at $2.4 billion. The feast in the hedge fund trough each year is the subject of great fascination and much tut-tutting.

Perception won’t pay off the mortgage

Hedge funds are seen as jet fighters in a prop plane industry. They’re expensive, freewheeling, and hard to get into – many require high minimum investments. It’s this velvet rope treatment that signals greater quality to many investors. Like the hottest new restaurant with a full reservation book, those on the outside looking in don’t care what it costs; the exclusivity alone justifies the pricey fare.

Across most markets investors and regulators have cried out for more transparency in recent years, but in the hedge fund world the general lack of transparency seems to be part of its value proposition. Perhaps the less some of us know about a product the more willing we are to view it as valuable. It doesn’t make sense to me personally, but who am I to judge?

Much ado

In my experience, despite all the enthusiasm for hedge funds and supposed great returns, I have never met an individual investor who put enough in hedge funds (at least 30% of one’s portfolio) to make much difference. For my money, except for operators, hedge fund investments remain great cocktail party chatter. We’ll stick with index ETFs here.

John Osbon – josbon@osboncapital.com