The Hedge Fund Paradox

Returns are low but investors still love them.

Why would you pay more to earn less? That is the question investors in hedge funds ought to be asking themselves:

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The return on hedge fund investments has averaged about 7 percent a year since 2009, according to statistics from the consultancy Hedge Fund Research. That’s well below the annual return from a simple investment in the S&P 500 nearly every year since 2009 except for 2011.

Hedge funds with volatility investment strategies, betting on the ups and downs of the market, were the best performing according to Hedge Fund Research, increasing 5.5 percent in 2014. Funds that invested in Latin America were the biggest losers down a whopping 20.2 percent, followed by those dedicated to energy which dropped 12.4 percent. Smaller funds were hit harder than the larger funds. Most of the industry wound up in the red in 2014, according to the researcher.

Oddly enough the poor returns don’t seem to deter both professional and individual investors. The global hedge fund industry has seen a $76 billion net inflow of assets through the first half of 2015, bringing the size of the industry to $3.22 trillion, according to the consultancy Prequin.

Even worse, the actual returns are likely lower than the statistics show.  That is due to most Hedge funds being private companies, so they have no obligation to report whether they are making money or not. You can imagine a fund manager who is not performing well would not want to publicize their results. The end result is many hedge funds just go away because they either implode or are dissolved due to poor returns. These funds are never included in the index return numbers.

Pension funds seem to be the slowest learners. According to a report published by the Roosevelt Institute in November, which looked at 11 pension funds, hedge fund net return rates were up to 75 percent below the rates of return for the pension funds themselves. That low rate of return cost pension funds about $8 billion in lost investment revenue. Yet, pension funds continue to pay an average of 57 cents in fees to hedge fund managers on every dollar they earned for the funds.

Some pensions are finally starting to wise up. CalPERs, the California state pension fund, the largest fund in the U.S. and one of the world’s largest investors, gave up on hedge funds in 2014.

So the questions remains, why do investors keep paying the high fees associated with hedge fund’s for low returns?  The appeal of hedge funds come from the fact that they are only available to ‘accredited investors,’ that is, investors with considerable experience and wealth. It’s possible the mystique is intriguing to investors because these investments aren’t available to the general public, so they seem to believe they are getting in on exclusive deals.

Hedge fund managers build up impressive reputations as financial gurus before they are entrusted with managing these large funds. For a pension fund, as well as for many individual investors, it seems safer to place their money with someone who has shown considerable success in the past, even though past returns are not indicative of future results.

 Perhaps billionaire investor, Warren Buffett said it best: Speaking at Fortune’s “Most Powerful Women Summit" on Oct. 14, Buffett pointed out that as hedge funds grow in size, managers have less incentive to provide better performance. To understand what he means you have to understand how hedge funds are compensated. Hedge fund managers usually receive two types of compensation: A 2 percent management fee, which is taken out of total assets. As well as, a 20 percent fee that comes out of total returns.

So, as Buffett pointed out, "When you have $20 billion in assets, you're getting $400 million just from management fees, so that 20 percent of performance becomes less important. You don’t have to particularly deliver. The promise of greater returns lasts long enough to make the hedge fund manager and their children rich.”

Simply attracting money to manage can become more important to the hedge fund manager than actually earning returns. If a particular fund performs badly, the manager can just shut it down and start a new one. Hedge funds are, in fact, being closed down at an extraordinary rate, with about 80 ceasing operations each month in the U.S., according to Hedge Fund Research. Most hedge funds last about five years, according to Prequin, and in 2014, about 800 funds shut their doors, the researcher said.

For example, Fortress Investment Group closed its macro hedge fund in October 2015, after losing a punishing 17.5 percent that year. But the fund’s chief investment officer, Mike Novogratz, left the company with a "small" parting gift of $255 Million.

With all of these disadvantages, experts say investors still turn to hedge funds for a portion of their portfolios. Prequin noted that there is a continued need for these products by institutional investors, despite any concerns around performance and fees. In light of recent equity market turbulence, the ability of hedge funds to provide consistent albeit low returns is still valuable to investors, Prequin noted in a recent report. Some hedge funds actually focus on reduced volatility at the cost of lower returns. This might sound like a good strategy but you can be sure they are not reducing their fees.

If you are skeptical of any of the investments in your portfolio be sure to reach out for a complimentary meeting and second opinion.