The problem with investing in hedge funds

By Felix Salmon
September 16, 2010

I had a fun time last night sparring with Cathleen Rittereiser, who brought along a couple of copies of her new book, “Top Hedge Fund Investors.” (Wiley, $60, but only $37.80 at Amazon.) Her elevator pitch was a good one: a lot of books have been written about top hedge fund managers, but this is the first to be written about the people who actually invest in hedge funds.

It turns out, however, that fund-of-funds managers and their ilk are even more secretive than hedgies. Even Rittereiser, who wrote this book in between stints working for various hedge funds herself, didn’t manage to extract any quantitative information about their performance: her criterion for being considered a Top Hedge Fund Investor is simply having been around a long time, or being responsible for lots of money. Or, I suspect, just being willing to talk at all.

This is my biggest problem with alternative investments in general, and hedge funds in particular. Think about the situation with mutual funds: people don’t feel qualified to pick stocks, which is reasonable, and so they get a mutual fund manager to pick stocks for them. Except there are just as many mutual funds as there are stocks, and it’s actually harder to pick a good mutual fund than it is to pick a good stock.

The problem is even worse with hedge funds, because they’re so secretive. If you want to invest in hedge funds, how can you get a good impression of what your options are and which is best? It’s very, very difficult. And so you turn to a fund-of-funds manager. But how do you pick them? It’s even harder.

As far as I can tell, the main way that people end up investing in hedge funds is that their private bank is also a prime broker for various funds. And so the two arms shake hands, as it were: the private-bank clients get introduced to the prime-brokerage clients, and money ends up flowing from the former to the latter.

That’s all well and good, but in an era when prime brokerages compete for hedge funds by extolling the depth and wealth of their private-banking client base, said client base might want a bit more objective advice as to who they should be investing with. Including, of course, unaffiliated funds.

It’s easy to go wrong in hedge-fund investing, either by putting money into a fund which blows up, or by diversifying into so many different funds and strategies that you end up diversifying away all your alpha as well. And paying a management fee to a fund-of-funds investor only makes it even harder to get any financial benefit out of investing in hedge funds.

My feeling is that most individuals who have done very well out of investing in hedge funds have done so mainly by luck: by knowing the right person at the right time. A few top endowment heads and the like know the lay of the land quite well, and have access to just about any fund they want. But unless you’re running a multi-billion-dollar endowment, and being paid a lot of money to do so, it’s hard for me to see how you can successfully invest in hedge funds through anything other than luck.

Comments
11 comments so far

That’s *exactly* what Willie Aames is saying.

http://www.youtube.com/watch?v=vOD5kcsaW MM

Posted by Uncle_Billy | Report as abusive

I don’t understand how you can diversify alpha away? I thought alpha was independent of any effects of diversification. Unless you mean that by investing in so many funds, the diversification results in having some funds with negative alpha, resulting in a net zero alpha.

Anybody have some insight into this, and the mathematics of alpha in a diversified portfolio?

Posted by mickey7410 | Report as abusive

I’m not sure I agree with you about choosing a good Mutual Fund, but you are right about hedge Funds. Every time I’ve compared the average Fund of Hedge Funds Fund to the average Mutual Fund there’s been no statistically significant difference between the two; the only perceptible difference I can see is that Hedge Funds carry much more charge eg the amazingly high “Success” Fee, charged as a percentage of profit over a given amount.

Hedge Funds are no more than a clever way to extract more money from investors.

Posted by FifthDecade | Report as abusive

Managed Futures funds tend to earn what fees they charge relative to long-only asset pickers. Allocating some money to a generic managed futures / CTA fund should improve the risk-adjusted returns of a traditional asset portfolio.

Posted by Jason_Ruspini | Report as abusive

Pick a FoHF which has been around for a long time and has 10bln AuM or more.

Posted by jrmlal | Report as abusive

Felix,
This is one of the most misguided posts I have ever read. The reason for hedge fund and fund of funds “secrecy” about returns is by directive of the SEC. The interpretation of the laws about advertising to non-qualified purchasers or non-accredited investors is quite broad. So if a manager lists his or her performance in a book or other publication that can be distributed to retail investors, the SEC can basically come in and shut them down or fine them substantially. It is by desire of the funds to avoid regulatory problems. In this business even a hint of running afoul of the SEC could ruin reputations and someones business. The popular misconceptions about hedge funds in the press does not serve anyone well. I am happy to discuss if you like. These SEC rules also apply to all non registered investment vehicles.

Posted by mjfitz9 | Report as abusive

@mickey Theory goes like this… The more you diversify, the closer to market portfolio you hold. Market portfolio by definition has no alpha, ergo: more diversified portfolio equals less alpha.

Posted by MRLAMF | Report as abusive

Love the angle that it’s the SEC causing the lack of Hedge Fund transparency. LOL! If this is true, then surely this is a result of the choice of Hedge Funds to be located in offshore havens with limited regulation?

If they are non-registered, non-regulated vehicles it’s no surprise they are scared of giving “investment information” since it is an offence to transmit such data across the International borders of the United States.

Perhaps if they had not run away from jurisdictions where they could be properly regulated, those same jurisdictions wouldn’t be so restrictive about letting the Hedge Funds participate in the normal investor-facing investment environment?

I know the Hedge Funds are stuffed with incredibly clever people, but maybe they think they are too clever for the rest of us and don’t feel the need to be transparent. After all, it’s only OUR money they want to play with.

Posted by FifthDecade | Report as abusive

The diversification thing is actually quite common among holders of Mutual Funds. By holding lots of active funds, you essentially get market performance, but you’re paying active management fees. No wonder people are flocking to index funds. At least there the fees are minimal.

@FifthDecade: read the Investment Company Act of 1940 some time. Then read some SEC enforcement cases. Hedge funds operate with special registration requirements that allow for lockups and other contract provisions. Hedge funds aren’t an asset class, they’re a legal vehicle. So the law matters.

Posted by Publius | Report as abusive

In my time at the hedge fund, I met quite a number of hedge fund-of-fund investors. Only one impressed me with their acumen, and they made the mistake of not investing with us. They were bright, but misunderstood some things the head manager said.

Odd, they had a good theory, but couldn’t get the data. Most HFoFs don’t have a good theory, they just chase performance.

Posted by DavidMerkel | Report as abusive

So will you trust Willie Aames the actor twice bankrupt who is just starting, or Clinton’s daughter who is also just starting but has a name to trust (tongue in cheek there) and a husband who is a banker?

Or will you trust the husband of a colleague who was a reformed drug dealer thug with links to organized crime turned Bay street wheeler dealer and presently a hedge fund manager (and soon after also got a law degree) who did pick them in the past?

All three have the same credentials, so whom do you trust to tie up your money and take exorbitant fees to make that fortune? Dan Ariely says it may be that if two look similar, the manager who is the least ugly when you speak to them in person. Or, perhaps if one is investing in Telecom and you did well prior investing there, you could choose there for that reason.

In actuality none sound like sound choices, but people do it anyway because they want to make mo money
http://danariely.com/bits-and-pieces/

Hedge fund manager turned entrepreneur with OPM locked in to fund his ventures.
http://www.reuters.com/article/idUSTRE67 P22J20100826

@mjfitz9 who said: “It is by desire of the funds to avoid regulatory problems.” And I would say it is normally the design of the funds to avoid/skirt regulation.

Posted by hsvkitty | Report as abusive
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