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Can a monkey pick a hedge fund?

Date: Wednesday, October 26, 2011
Author: Brett Arends, MarketWatch

Hedge funds are scary. They are complicated, confusing and risky. If you’re a rich investor — the member of a wealthy family, say, or someone running a big endowment — you need someone to help you pick the right ones and avoid the disasters.

To help you out, we’ve assembled two teams.

On the one side we have assembled a highly professional group of investment advisers running a “fund” of hedge funds.

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The team will greet you in their beautiful offices on the waterfront in Greenwich, Conn., or maybe Palm Beach. A beautiful secretary will serve you a beautiful cappuccino with just the right amount of cinnamon and nutmeg on top.

The members of your team boasts MBAs from Harvard and Stanford, and resumes packed with blue-chip names from Wall Street. They have wonderful PowerPoint presentations to show you how they will help you manage your money. They will impress you with their strict, “disciplined” investment process. They are tough on “alpha,” “beta,” and risk-management controls. They check out each fund thoroughly.

On the other side we put together a group of monkeys kidnapped from the local zoo.

They hang off a tree while we feed them peanuts and bananas. Then we make hedge-fund managers walk past the tree. The monkeys throw peanuts, bananas and anything else that comes to hand.

If something sticks to a hedge-fund manager, we select him for the fund. If it doesn’t, we don’t.

Which investment approach does better?

I believe in reason, logic and the human mind, so I wish I could say the first. Alas, I have just finished reading “Assessing the Performance of Funds of Hedge Funds,” a research paper produced by Benoit Dewaele and Hugues Pirotte of the Universite Libre de Bruxelles (the Brussels Free University in Belgium), and Nils Tuchschmid and Erik Wallerstein of the Geneva School of Business Administration in Switzerland. The paper is here.

They studied a broad sample of 1,300 funds-of-funds from 1994 through 2009, and analyzed just how much value they actually created.

Their core finding? When you strip out the fees, just 22% deliver any “alpha,” or risk-adjusted investment gains, at all.

And most of those gains came from the underlying hedge-fund indices, rather than from picking the right individual managers.

How many actually added value by picking the right managers, and avoiding the wrong ones?

According to the study, just 5.7%. That’s right. After deducting fees, just one fund in 20 actually added risk-adjusted returns above those of the underlying hedge-fund indices.

You couldn’t make it up.

Nearly half of all Fund of Hedge Fund managers, the academics report, delivered “negative after-fees alpha when benchmarked against the hedge-fund indices.” In other words they couldn’t even keep up with the index.

(Ah, “negative alpha.” The euphemisms we use these days. It’s enough to make you visit the nearest comfort station.)

The managers also compared the performance of actual fund of funds to randomly selected groups of funds. The differences were minimal.

They conclude that the fees associated with funds of hedge funds wipe out any added value. And their comparison of funds of hedge funds with randomly selected groups of hedge funds “would moreover suggest that such hedge-fund picking skills are on average close to non-existent in the first place.”

And this game isn’t penny-ante stuff either. These funds have about $560 billion invested in them, after peaking at $1.2 trillion in 2007.

Adding insult to injury: Most of the underlying hedge funds themselves aren’t adding value either — at least, not to the investors.

As Ilia Dichev at Emory University and Gwen Yu at Harvard found, after looking at hedge-fund performances over the past 30 years, the average has done worse than a stock-market index fund — and not much better than a simple basket of Treasury bonds.

No wonder the monkeys in the zoo always seem to be laughing. They’re looking at us.

Brett Arends is a senior columnist for MarketWatch and a personal-finance columnist for the Wall Street Journal.