Hedge Funds: Heads they win, Tails you lose?

Hedge Funds: Heads they win, Tails you lose?

"I'll tell you what I think of hedge funds. Hedge funds are a huge fad. You can pick any ten hedge funds and I'll bet that on average they will under perform the S&P over the next ten years. You can't create more money out of American business than the business itself creates; so most of these hedge funds will not be able to justify their outlandish fees over the long-term and they will disappear. On Wall Street, there are innovators, imitators, and total incompetents. I'm afraid that the majority of hedge funds around the globe now are run by the latter two categories of people." Warren Buffett

"Hello. My name is John Merriwether." In 1996 I met the "Master of the Universe". John Merriwether, as Vice Chairman of Salomon Brothers, was the hero of the book "Liar's Poker", written by Michael Lewis. In the famous scene with Chairman John Gutfriend he out-bluffed his boss in the game that was played on the trading floor. Merriwether was the head of the arbitrage desk at Salomon brothers. His team of "quants" generated enormous profits for the bank and became the highest paid individuals on Wall Street.

However, this groups? best show was yet to come. In the early nineties they started up their own hedge fund LTCM (Long Term Capital Management). As an independent hedge fund they took their trading to the next level and, in addition, hired 2 Nobel Prize winning scientists to their team. The brain power and trading expertise seemed unstoppable as spectacular returns were achieved for their investors. For this team the normal limits did not seem to apply, at least for a while.

Their head trader in Europe and one of their most successful traders was Victor Haghani. He had asked to spend some time on the proprietary trading desk at J.P.Morgan in London, where I was working. We talked shop for a while and although I found our discussion very interesting I did not think any more about it. Until, shortly after, I got a phone call to visit the LTCM offices in Mayfair. They said they wanted to talk more about trading and, of course I was curious. I was naive enough that I had not realised this was an interview to join their team of superstars, until after I had arrived. I had not prepared for this and may not have made the best impression.

It was just as well. Within two years LTCM had over-leveraged and collapsed with such large positions that the Federal Reserve stepped in to organize a rescue group. The remarkable story of LTCM is brilliantly told in the book "When Genius Failed", by Roger Lowenstein.

What does this story tell us about hedge funds? Even the best hedge fund you could hope to be invested in, like LTCM, may not know it's limits, or can easily spin out of control. Success leads to bigger and bigger positions. At a certain stage it becomes difficult to reign in and control the most successful traders. Can you rely on a young and astronomically well paid trader to know his limits, to not be overwhelmed by success and a sense of invincibility? How can you know when a hedge fund has switched from being remarkably successful to dangerous? If highly successful hedge funds are dangerous, can it make any sense to invest in only moderately successful hedge funds, when the fees are so high?

Let's look at the case for hedge funds. Is this the new and improved structure for excellence in fund management or, as Warren Buffett suggests, a compensation strategy for some money managers.

Aggressive attitude
I have always had a problem with hedge funds. One reason is that the attitude is aggressive right from the outset. The premise has no humility. If I want someone to manage my capital, which for me is extremely rare, I want them to balance the risk and return, wait for the right opportunity at the right time. I want them to be patient and disciplined, even do nothing until the great opportunities emerge.

However, the incredible fee structure is not arranged in a fashion to support many of these necessary characteristics. Just look at the fees they charge. There are variations, of course, but the standard 2% management fee plus 20% of any positive return, has always seemed excessive. Lets consider what this means.

Hedge fund return Hedge Fund fees Investor return
-10% 2% -12%
7% 3% 4%
12% 4% 8%
20% 6% 14%

What is clear from this table is that unless the hedge fund managers are themselves invested in the fund, the investor bears the full force of any downside in the fund's return in addition to fees. As the fees rise dramatically with positive returns the compensation structure is clearly in favour of the managers taking greater risks to raise their chance of higher rewards, regardless of market circumstances. If it does not work out then the managers may not be well rewarded but they will at least not lose any money, although possibly a few clients for the following year.

So why do investors seem so prepared to hand over their money to hedge funds? Beats me, because for all these high fees and high risks that are being taken with their money they do not even have such a great upside. Very few managers are capable of achieving consistent returns of over 20%. George Soros and Warren Buffet have been able to do this over a few decades but really they are in a very small minority. So lets? assume you are very fortunate to invest in a hedge that consistently pounds out 20% returns. You get only 14%. A big chunk of those returns disappear in fees. All that risk for admittedly good returns but not outstanding, even in the best of circumstances.

So lets? recap. Hedge fund investors have high fees, in addition they have all the downside, but their upside returns are heavily capped. Is it surprising that hedge funds are often described as a "heads they win, tails you lose" proposition?

Liquidity and Disclosure?
So for all these great fees and high risk, aren't there other benefits? Not really. There is very little disclosure about what is happening to your money, and if you want it returned it can sometimes take up to three months to get it back. Investor protection is much reduced as well, although currently undergoing review. Wealthy investors who are prepared to pay high fees should be treated better in my view.

How about the returns?
Hedge fund returns have been below 10% on average over the last six years. As the sector has exploded in size and number in recent years average returns have fallen. It is no longer clear that hedge funds are providing the superior returns necessary to make up for their many disadvantages.

Hedge funds have grown dramatically in recent years. There are now some 8000 or so of them, somehow attracting institutional investors as well now, so that total assets amount to about $1.2 trillion. Yet hedge fund returns have averaged below 10% over the last six years.

The popularity of hedge funds emerged when investors perceived a need to diversify away from "buy and hold" investing. However, just because market conditions change in ways that make hedge funds look more attractive, does not necessarily make hedge funds the right solution for most investors.

The fee structure for hedge funds is not only very high but it also leaves investors with a capped upside but unlimited downside. Conversely, hedge funds are richly rewarded by high fees and the clear incentive to take high levels of risk. This should be a matter of acute concern to investors. Long term returns do not necessarily rise just because greater risks are taken. Just consider technology stocks in the last decade.

Optimal investing is about maximising returns, while minimising risks, and lowering your costs as much as possible. Whether you are maximising returns by investing in a hedge fund is highly debatable, but for sure you are not minimising your risk, or lowering your costs. Furthermore, with a hedge fund you do not have access to your account information at any time on any day, and you can not withdraw money whenever you wish.

Surely it makes far more sense for investors to find an experienced Registered Investment Adviser, with a great track record and experience, who charges a reasonable flat fee for very efficient and effective asset management. Transparency and dialogue is then also possible with your manager, who is legally obliged to act at all times in the clients best financial interest, and must declare any and all conflicts of interest.

Maybe a hedge fund manager will provide a better return, and maybe not, it will surely be hard to tell in advance. However, there can hardly be any doubt that the cost and structure of a relationship with a Registered Investment Adviser is far more attractive to the investor. The optimal strategy for most investors should therefore be clear. Find a Registered Investment Adviser, who can manage your capital to your liking.