Reply to
@scott:
Hi Scott,
Thanks for your thoughtful and thought provoking reply. It expanded both the thinking and opinion horizons on the topic. Great stuff.
We both see the gathering Hedge fund dynasties in much the same light. I agree Hedge fund managers are very likely smarter than Mutual fund managers. Hedge funds draw their cadre from the superior performing mutual fund management pool. However, successful financial wizards often fall victim to excessive ego trips caused by an overestimation of skill sets and an underestimation of the luck contribution to their performance story.
There is little doubt that Hedge funds have prospered recently as their numbers and their increasing wealth accumulation have been nothing short of phenomenal. However, it is not clear if that wealth accumulation has filtered down to the private investor level.
The financial sector is populated by plenty of smart folks. But smart people do not always produce superior outcomes. Many books have been produced that fully document that observation.
Simon Lack has generated a scathing book of hedge fund failures in his “The Hedge Fund Mirage”. He observes, with a distortion of Sir Winston Churchill’s famous World War II remark, that “Never in the field of human finance was so much charged by so many for so little”.
The books opening, eye-popping statistic reveals that if all the money ever invested in hedge funds had instead been safely placed in US Treasury Bills, the returns would have been double those delivered by the inventive and the undisciplined Hedge fund army. The industry does have a few outstanding exemplars; their impact is severely diluted by the more numerous miscreants and copycats.
I’m thinking now of the likes of John Merriwether’s LTCM over-leveraged demise, of Amaranth Advisors highly publized 2006 failure, and of course, of Bernie Madoff’s malfeasance and disgrace.
A few papers on the Hedge fund industry highlight this aspect from several perspectives, both supportive and otherwise. On an anecdotal basis, the Hedge fund record, at least that fraction of it that the average investor has access to, is littered with startling survival dropouts and shocking return disparities.
Immediately following are two distinguished references that take opposite sides of the Hedge fund risk-reward controversy. The first is coauthored by Burton Malkiel of “Random Walk Down Wall Street” fame; the second is by a less well known authority, George Van from Van HF Advisors International who wrote that the Malkiel-Saha paper was deeply flawed.
A Link to a summary the Malkiel-Saha paper by the authors themselves follows:
http://www.frbatlanta.org/news/conferen/06fmc/06fmc_malkiel.pdfThe Link to Van’s paper is:
http://www.intelligenthedgefundinvesting.com/pubs/rb-gvzs.pdfNote that both references were generated by vested interests and are likely to have views that are shaped by a divergent set of financial incentives. A basic understanding of the motivations underpinning any source is critical when assessing the merits and shortcomings of the position advocated.
A more balanced, and perhaps less biased study was reported by Morningstar. The work was headed by Roger Ibbotson and is titled “The ABCs of Hedge Funds”. It includes data through 2009. Here is the Link to the paper:
http://corporate.morningstar.com/ib/documents/MethodologyDocuments/IBBAssociates/ABCHedgeFundReturns.pdfThe paper shows that “results indicate that both survivorship and backfill biases are potentially serious problems. Adjusting for these biases brings the net return from 14.88% to 7.70% for the equally weighted sample.”
This is yet another buyer beware cautionary signal. You get to choose your own poison. The debate and the controversy, even about the data sources, rage with spirited interchanges.
George Soros surely demonstrated the Midas Touch with his currency genius, gambles, and attacks. In 1992, Soros's Quantum Fund became famous for "breaking" the Bank of England, forcing it to devalue the pound. The Quantum fund is no longer available to outsiders, but had a sterling record under the leadership of Soros, Jim Rodgers, and Stanley Druckenmiller. It’s funny to recollect that I once tried to become a client, but didn’t satisfy their high net worth standards.
Consider Julian Robertson, his Tiger fund, and his long-short investment strategy. It worked until it stopped working. He closed his Tiger fund in 2000, but is still an active player by providing seed money to promising Hedge fund manager candidates. He is a brilliant investor as are Myron Scholes and Robert Merton, Noble Laureates, whose analytical models contributed to the LTCM problem.
The risks for a small investor is the potential for massive losses. The potential upside is extremely limited when considering the long term persistency requirements of most investors, and the eroding effects caused by high annual fees,
The huge disparity of Hedge fund historical performance among its numerous categories is still another cause for caution.
Hedge funds have a checkered record, even under the watchful scrutiny of institutional agencies like Harvard, Princeton, and Yale. The managers of these endowments split their resources between conservative Index holdings and far more aggressive Hedge fund operators. If these super-investors can not make a definitive decision, it is a daunting challenge for even a knowledgeable private investor. If selecting an active mutual fund manager is like walking through a briar-patch, deciding on a Hedge fund manager must be like choosing a pathway through a minefield.
The diverse categories that populate the Hedge fund industry add to the confusion and uncertainty. Performance differences between these categories are huge and unstable over even intermediate timeframes. The rewards are there, but so is the risk, especially for an individual investor who is typically denied access to the truly superior Hedge fund managers. These guys are few, and their best interests are served by seeking institutional clients. You know who they primarily serve.
From my perspective, the Hedge fund waters are too murky for the individual investor. The reporting is spotty and the regulations are too thin. Navigating these less well charted choppy waters is too demanding a sailing chore given the uncertain risk-reward tradeoffs.
Thanks again for your fine submittal.
Best Wishes.
