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.
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