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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