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Behind-the-scenes New Yorker article on hedge funds reveals they aren’t so sexy

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John Cassidy’s fascinating behind-the-scenes look at hedge funds in the recent New Yorker is eye-opening. When you think of hedge funds, do you think glamour and prestige?

In a study published in the June, 2003, issue of the Journal of Financial and Quantitative Analysis, he and a co-author, Gaurav Amin, an analyst at Schroder Investment Management, a British financial firm, compared the fee-adjusted returns of seventy-seven hedge funds between 1990 and 2000 with the returns generated by a market benchmark that had a similar risk profile. Seventy-two of the funds—more than ninety per cent—failed to outperform their benchmarks.

With the help of a graduate student, Helder Palaro, Kat also undertook a larger study, in which he examined more than nineteen hundred funds. The results, which Kat and Palaro posted online as a working paper last year, showed that only eighteen per cent of the funds outperformed their benchmarks, and returns even at the most successful funds tended to decline over time. “Our research has shown that in at least eighty per cent of cases the after-fee alpha for hedge funds is negative,” Kat told me. “They are charging more than they are adding. I’m not saying they don’t have skill; I’m just saying they don’t have enough skill to make up for two and twenty.”

[…]

In a widely discussed 2005 paper, Burton Malkiel, a Princeton professor, and Atanu Saha, a New York investment analyst, argued that many published estimates of hedge-fund returns are misleading. Malkiel and Saha discovered that funds tend to exaggerate how well they performed in the past, and that those which perform badly often close and disappear from databases, leaving a biased sample. After examining results of now defunct firms, Malkiel and Saha found that between 1996 and 2003 hedge funds made an average return of 9.32 per cent, significantly less than the 13.74-per-cent average return of funds included in the published databases.

Yet again, for regular investors like you and me, we see the difference between sexy and rich. What’s interesting is that even for regular investors NOT like you and me — that, people with access to hedge funds — even they may be getting substandard returns in exchange for their participation in hedge funds. This is just another example of investor psychology and the importance of realizing that people are not always rational with their investments.

With all that said, I know a couple of fund managers and hedge funds are an important part of their asset allocation. For more info, see David Swensen’s books (for personal investors and for portfolio managers). The first book is the definitive book on asset allocation, which I haven’t spend much time on yet, so if you’ve been wondering how much to put in stocks vs. funds, international vs. domestic, etc, pick up this book.

Also, see my previous articles about mutual funds (not) beating the market.

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pdq
pdq
9 years 2 months ago

Link to Cassidy’s article?

Will
9 years 2 months ago

Interesting, but I wouldn’t consider the New Yorker the last word on financial reporting. Hedge funds are definitely making money for savvy, rich investors, but these same investors are people who can deal with downsides. Likely, these are not people who read your blog since they don’t need to be taught what they are are (rich!). That’s not me yet and as such, I will continue to be a Ramit devotee.

Example: Since 1988, the Renaissance Technologies Corp.’s Medallion Fund has returned 35.6%. Not too shabby, imho.

Road To Harvard
9 years 2 months ago

Ramit, I was wondering how you paid for your undergraduate education? I have been browsing the site and cannot find any article that addresses this. If you could point me in the right direction it would be appreciated.

Jenna
Jenna
9 years 2 months ago
One thing that readers must realize is that while yes, it is true that while many hedge funds do not beat the market, the risk associated with the returns is often lower. Often the volatility of hedge funds is significantly lower that the volatility of the market – and, often a large portion of reported volatility has to do with fat tails on the right side of the distribution curve proving the ability to protect capital on the downside. Having lower risk allows portfolio managers to allocate risk to other asset classes. With the market currently in such a bull… Read more »
Rogers Place
9 years 2 months ago
Most times these lower looking yields will earn you more in the end. With lower risk does generally come lower returns. But compared to what.? No one can preidct the future, only show you past performances of a particular fund(higher yielding in this case). With the potential for a higher return comes higher risk of loss. So 25 years from now the higher yielding fund may actually be worth less, it took several large losses in years 13, 17, and 25. Where as your lower yielding hedge fund gained every year, not alot but enough to significantly outway the higher… Read more »
Andrew
Andrew
9 years 2 months ago

One of the first comments on this post mentioned that 35.6% return for Renaissance Technologies.
Remember, though, that any broad investment universe is going to have that rarified group of top performers. Since the majority of the historically best hedge funds (that are still in operation) are closed to new investors, the trick becomes trying to find another Renaissance type of fund. This is the hard part, and this is the reason why looking for a hedge fund that is still accepting new investors is no guarantee for any risk-adjusted alpha whatsoever.

Mark Holden
Mark Holden
9 years 2 months ago
This should come as no surprise to anyone who’s read anything by John Bogle (founder of Vanguard) on investing. The above thesis is pretty much his axe, and he grinds it relentlessly — for example, in Common Sense on Mutual Funds. Clearly it is possible for individual investors/funds to beat the market; some even manage to do so intentionally and repeatedly (Warren Buffet comes to mind). But the vast majority of funds don’t, and it’s really hard to pick out the ones that will in advance. Actually, it seems surprising to me that Bogle isn’t mentioned, as the studies’ claims… Read more »
trackback
7 years 11 months ago

[…] 2. Hedge Fund Surprise? This is like a tuna surprise, only worse: Hedge Funds Are Bracing for Investors to Cash Out. Many people haven’t heard about hedge funds’ redemption clauses, which basically means that fancy investors (e.g., universities, pension funds, and really wealthy people) will be able to withdraw their money today (Tuesday, 9/29/08). If that happens, nobody really knows what the repercussions could be…but they would probably be Very Bad. I’ve previously written about why hedge funds are overrated for investors. […]

Khyron
7 years 10 months ago
Also be aware that Harry Kat is well known for attempting to create (or creating) hedge fund replication investments, essentially trying to replicate the performance of certain hedge fund indices (a bit absurd already) by reverse engineering them, thus harvesting alternative betas at a much lower cost. Much of his non-academic living is made by disparaging the hedge fund industry, which admittedly, is mostly worth disparaging. However, Kat is trying to sell something too, just something different. (And not so different, really, since he’s attempting to replicate the performance of the better players in the HF universe. Thus, if all… Read more »
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