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The hedge fund con explained

Ben Chu

mirage 150x150 The hedge fund con explainedIn The Independent’s Outlook column this morning I described the hedge fund industry as a “con”.

Those are strong words and require something to back them up.

My analysis is based on Simon Lack’s The Hedge Fund Mirage.

The crucial point, which I referred to in the article, is the difference between time-weighted returns and money-weighted returns.

Using the former, Lack calculates that the returns of the hedge fund sector as a whole (using the HFRX index) were 7.3 per cent per year between 1998 and 2010.

Using the latter, the annual return was just 2.1 per cent between those dates.

So how to explain the difference? Time-weighted looks at how $1 invested at the beginning of the period would have performed. Money-weighted adjusts returns for the amount of funds the sector has under management.

As Lack puts it: “It’s the difference between looking at how the average hedge fund did versus how the average investor did”.

This is hard to explain in prose. But thankfully Lack provides two charts which make the point well.

Here’s the annual per cent returns of the sector (“AUM” means “assets under management):

HF NEW 1 The hedge fund con explained


So, a stunning performance in the early years. A very bad year in 2008. But reasonable pick up since. This is essentially what investors are seeing when hedge fund managers point to time-weighted average fund returns.

An investor thinking of putting money in hedge funds might look at this and think: why not?

But here’s the returns of the sector in cash terms, so reflecting just how much money is under management:

HF NEW 2 The hedge fund con explained


This is essentially what investors are seeing when they look at the sector’s money-weighted returns (not that they are ever shown this less flattering picture in prospectuses).

Here’s what these two charts are telling us: In the late 1990s, when hedge funds were relatively small and were managing relatively small amounts of investors’ capital, they delivered spectacular returns. But then as more and more money was channeled into them (mainly by lumbering institutional investors like pension funds) the performance deteriorated. And as Lack points out, in 2008 the hedge fund industry lost more more money than all the profits it had generated during the prior 10 years. The chart finishes in 2010, but those losses still haven’t been recouped by the sector in the years since.

So which is the appropriate measure for evaluating the sector’s performance? The hedge funds argue that the time-weighted measure is reasonable because this is how one measures stock-market returns or the performance of mutual funds. But what this ignores is that hedge fund investments are not like buying equities or putting money in a mutual. Why? Because the investment cannot be withdrawn at will. You can sell a share when you think it will fall in value. But as many naive investors found to their horror in 2008, you can’t pull their money out of a hedge fund when it’s tanking.  You’re going down with the ship. Private equity funds use money-weighted returns in order to reflect the fact that investments with them are illiquid. This is plainly the appropriate way to measure hedge funds too.

But does this make hedge funds a con? Sure 2.1 per cent annual returns is bad, but it’s still just about positive isn’t it?

Well, consider the 2% annual management fee charged by most funds on the capital under management. And then consider the 20% of annual profits that the funds cream off.

Lack calculates that investors in hedge funds have made $70bn since 1998, while managers have made $379bn.

HF12 The hedge fund con explained


But this overstates the returns of investors. Lack points out that the HRFX index does not capture the fact that many funds have gone bust, wiping out investors entirely. Adjusting for this shows that investors have lost an incredible $308bn since 1998, while managers have walked away with $324bn.

HF23 The hedge fund con explained


And if you don’t think that’s a con, by all means ring up your pension manager and encourage him to divert more of your nest egg into these great value money managers. Just don’t expect a comfortable retirement

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  • Pacificweather

    Nothing about this is surprising, even the time-weighted returns show that the more assets under management the less the return. It is self evidently easy to hedge a smaller amount of assets than a larger. What it demonstrates that is surprising is that numeracy is not the strong point of asset managers which, I guess, should not be as surprising as it seems.

    Is it a con or is it just naive gambling. Was selling novelty golf ball bomb detectors a con or was it corruption by the purchasers’ agents, or were the purchasers too credulous to be allowed out on the street.

    It all financial transaction required an end user certificate or be subject to a variable transaction tax dependent upon risk or transparency then fewer problems would arise. One thing is clear, governments need a hedge not only against hedge funds but all financial transaction that do not relate to a concrete investment or purchase.

  • john caulfield

    Using time weighted returns introduces an element of client discretion into the equation. Is it really fair to judge investment returns on the basis of clients putting money in at the top as they did in 2007, and pulling it out at the bottom as they did in 2009 and then crying foul?! If you are going to use this methodology you should compare time weighted returns accrued by equities through the same time period and to bond holders through a complete bull bear cycle such as the late 70s to early 80s. As a methodology it is completely unsuitable for measuring anything but the returns of the most illiquid investments. You should know this and state as much in your article, rather than just blindly reproducing someone else’s work.


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