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Dazzled by hedge funds? Look closer


Date: Tuesday, January 23, 2007
Author: Eric Reguly, Globe and Mail

The returns are in and anyone who owns a hedge fund, the hottest investment since the junk bond, maybe since the invention of capitalism, should be delighted. The benchmark CS/Tremont Hedge Fund Index rose 13.9 per cent in 2006, almost double the return in 2005. The fine performance should attract another supertanker-load of money to the $1.2-trillion-plus (U.S.) industry.

Or not. Viewed from another angle, hedge funds were the runts of the year. The total return of the S&P 500 index in 2006 was 15.8 per cent. The Russell 2000 index of small-cap stocks rose 18.4 per cent. Even the TSX, with a 14.5-per-cent gain, outpaced the hedge funds. For the privilege of underperforming the market, hedge fund investors got clobbered with the standard "2 and 20" fee -- 2 per cent of the assets and 20 per cent of the profits. Investors who owned funds that own groups of hedge funds (known as funds of funds) probably paid even higher fees.

To be sure, some hedge funds had a spectacular year. Funds that worked the emerging markets or the merger arbitrage game reaped gains of 20 per cent or so. The $7-billion European fund managed by Atticus Capital, the notoriously aggressive hedgie that put onetime Inco suitor Phelps Dodge into play, gained 44 per cent last year. Many others were duds. Goldman Sachs's monster Global Alpha fund lost about 6 per cent. And then there was Amaranth, torpedoed by $6-billion in losses, care of a young trader in Calgary named Brian Hunter and his wrong-way natural gas bets. The fees don't disappear if the fund sinks or merely underperforms the broader market. If you're a hedge fund manager, it's very much a heads-I-win, tails-you-lose affair.

By now, as the hedge fund industry has evolved from upstart to establishment status, it's apparent outsized fees do not guarantee outsized performance and that merely well-off investors (as opposed to the rich and super-rich, the traditional hedge fund customers) might be better off sticking with plain vanilla holdings, like mutual or index funds.

They won't, of course, because hedge funds are still glamorous, the equivalent of the private club cordoned off by the velvet rope. Never mind that the glam image is fading -- $25,000 or less can buy you entry into some funds. In reality, they're on the verge of becoming a retail product.

Hedge fund fans say 2006's relatively poor performance is no reason to go wobbly (with apologies to Maggie Thatcher). Last year was a standout for the broad markets, which were driven by high commodity prices, record corporate profits and never-ending takeovers. The relative performance could easily flip this year, with the hedgies coming out on top.

Hedge funds also have a better record of preserving capital when the going gets rough. In 2002 and 2003, the funds posted solid double-digit gains while the overall market went nowhere. Another reason to buy the funds is their creativity. They are always dashing off into uncharted territory -- China is one of the hot, new destinations -- and piling up lovely returns before the shameless imitators arrive.

So hang in? Not so fast. Historic hedge fund returns may not be as good as they appear. Professors William Fung of the London Business School and David Hsieh of Duke University, took a close look at hedge fund returns and concluded they are inflated. They examined the TASS hedge fund database (which serves as the foundation for the CS/Tremont index). TASS will tell you that average annual hedge fund return, after fees, was a respectable 14.4 per cent between 1994 and 2004. The good professors said the real figure should have been 10.5 per cent, or roughly the same as the S&P.

Why? Because they adjusted the return for "survival bias" -- the disappearance of dud, dying or dead funds from the database (the broad stock market indexes perform the same trick, though aren't as quick to boot out the losers).

They also adjusted it for "incubation bias." That's when hedge fund managers launch several funds but market only the ones that are doing well. You, and the fund indexes, don't hear about the rest.

Every year, the hedge fund industry soaks up $100-billion or more of new money. There are more than 10,000 funds of every description worldwide. As the industry expands, it's reasonable to assume that returns could fall. It's the old story -- more money chasing few opportunities. Or you could see more Amaranth-style blowups, as fund managers place riskier and riskier bets hunting for the spectacular returns that earn them spectacular fees.

If hedge fund returns don't beat the market, you can bet investors will start resisting the fat fees. Twenty per cent of the profits? Based on last year's performance, that would qualify as a genuine rip-off.

ereguly@globeandmail.com