Judging hedge funds

By Felix Salmon
April 17, 2009

Dan Molinksi wades into the hedge-fund benchmarking waters:

Rutgers also stresses that the sharp losses by hedge funds in 2008 were not nearly as bad as the huge decline in U.S. stock markets. It’s an argument that’s also been used repeatedly by the hedge fund industry itself in recent months to put a positive spin on their losses.

But William Bernstein, author of “The Four Pillars of Investing,” questions whether this comparison is sound, adding that “it’s human nature to pick the benchmark that makes you look the best.”

Some say hedge fund performance should instead be benchmarked to a typical portfolio of 60% stocks and 40% bonds, and say that one should also discount about 5% from the initial investment to account for fees and other costs.

If one uses this gauge, and considering the aggregate bond index rose by 5.24% last year, hedge funds’ 19% losses look bad, indeed, and should perhaps be questioned more thoroughly by their investors.

Bernstein is right: the whole point of investing in a hedge fund is that it’s an absolute-return vehicle and does not benchmark the S&P 500. If there’s any benchmark, it should either be Libor (or some other simple ultra-low-risk rate of return), or else it should simply be zero.

On the other hand, I don’t think that hedge fund losses do “look bad, indeed” against a typical portfolio.

Let’s say Peter and Paul both started 2008 with $100. Peter invested $60 in stocks and $40 in bonds; the stocks fell to $36.90, exactly mirroring the S&P 500, while the bonds grew by 5.24% to $42.01. At the end of the year, he had $78.91.

Meanwhile, Paul invested $100 in a hedge fund which lost 19%, and paid a 2% management fee on top. At the end of the year, he had $79.38, slightly outperforming Peter.

If you calculated things a bit differently, and ignore the 2% management fee while instead discounting Paul’s initial investment to $95, then Peter does come out slightly ahead: Paul ends up with $76.95. But really there’s not a lot in it.

What’s more, almost nobody invests solely in hedge funds: substantially all hedge-fund investors also have stock-market investments. So even if Paul might have been slightly better off investing his $100 in stocks and bonds rather than in hedge funds, the fact is that he already was invested in stocks and bonds: the question is whether he should invest everything in stocks and bonds, or rather diversify out of public markets by putting $100 into hedge funds. All things being equal, a more diversified portfolio is a better idea than a less diversified portfolio, so once again Paul doesn’t feel too bad about his decision to invest in hedge funds.
On the other hand, Molinski is entirely right about the sleazy underbelly of the hedge-fund world, as most recently displayed in the Barrett Wissman case. Because hedge funds aren’t allowed to advertise their services overtly, a dank and secretive ecosystem of often-unpleasant middlemen has evolved with the purpose of putting funds and investors together. This world involves all manner of backhanders and dodgy-looking “fees”, and is largely ignored by the press, except for when it erupts into outright fraud. It’s a good reason to avoid hedge funds, especially when you’re introduced to them by smooth-talking salesmen who are less than fully transparent about how they’re being paid or how exactly they found you in the first place.


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Felix, I agree. I’m not sure what Bernstein’s point is. The choice of benchmark is generally tied directly to the prospectus of the fund; it is a function of investor demand and the type of hedge fund. Not all hedge funds are seeking absolute returns in all market environments, and most have a very specific mandate that may be completely orthogonal to the returns of a “typical portfolio of 60% stocks and 40% bonds”. What on earth is a “typical portfolio” these days anyway? It doesn’t make sense to compare the returns of different asset classes, since investors are deliberately allocating to a broad set of strategies. You could argue that some strategies are ineffective and should not exist, but otherwise you’re comparing apples and oranges. It makes perfect sense to compare a long-only fund to a broad-market index; it makes absolutely no sense to compare, say, a merger arbitrage strategy to a bond portfolio.

Posted by Jacob | Report as abusive

It is a good article, benchmarking a hedge funds performance is rubbish, they aim or are at least supposed to post positive not negative returns, they charge high fees for this ability, therefore when they lose money life is tough.

On the fee point you make, most funds post Net returns for the period in question, so if you have a fund which publishes a 19% decline, that would typically be after management fees.

One area that is going to be interesting going forward is how firms that are down say 20% from their high water mark at the end of 08 make up that short fall to earn performance fees (which would also be taken out if it was a +19% return), one would have to toil very hard to with no incentive to get back to zero giving an incentive to just close the fund. Some funds that I work with are looking at methods where you can earn 50% of the normal performance fee if you are ‘working off a deficit’ you would then as a quid pro quo have to continue to earn 50% for a period after getting back to your high water mark.


Posted by Chris Allison | Report as abusive

Hedge funds add a layer of FAT on top of existing management of the companies that they take over. They operate with profit margins of up to 95% and in legal ways they are very much like what the old mob used to be. They drive up cost, they are not motivated by the same forces that the Entrepreneurs who started the companies had. Many are headed by former political, social and ex military people who have used their office and leverage access to large sums of money from any source, both scrupulous and unscrupulous. It is not uncommon for a former political hack to go to work for a bank, hoard up a sum of money and then spin out some venture one penny stocks, in short they are schemers. They should be taxed out of existence. The path from civil service to this form of Intrapreneurhip that is like a form of modern feudalism should be bulldozed when the hedge fund moves into more than one company. Much of it started in England and spread to the US and when we think of all the trillions lost, in most cases it is a hedge hog that has gobbled up the money like so much slop. They are people with to much money and no sense, moral or otherwise. They are corporate feudalism and bad for capitalism and entrepreneurial-ism. They are hogs.

Posted by Sam | Report as abusive

the 2% fee is already implied in the -19% return, so Paul had $81 at the end of the year….

Posted by fred | Report as abusive

Your article starts out fair and balanced, but you can’t help but lapse into the currently popular anti-hedge fund rhetoric. Yes, there is fraud in the hedge fund world (as there is in any field that involves huge sums of money), but that is no reason to vilify an entire industry. Look, hedge funds are marketed to supposedly sophisticated investors who should be able to perform a thorough due diligence, or hire someone who can, before they invest. There are always predators willing to prey on those that are looking for something that is too good to be true and don’t want to do their homework.

Having said that, I do believe that strong regulatory oversight is long overdue in this industry.

What I think you are trying to say, but don’t actually state, is that the additional risks may not be worth the returns that, on average, does not markedly outperform the averages. This is a valid point, but I guess it does not promote readership as much as playing to the anti- hedge fund populace.


Can you explain how easy it is for someone’s 401K or IRA account to be transferred in entirety to a hedge fund on the advise of one’s financial adviser without any fiduciary responsibility on either the part of the adviser or custodial institution who launders someone’s life savings when it turns out that the hedge fund is a fraud? This would be most appreciated.

Posted by Anonymous | Report as abusive