Thursday, August 2nd, 2007
To Make a Small Fortune in Hedge Funds, Better Start With a Big One
By Martin Hutchinson
Director of Global Equity Research
Hedge funds and private-equity funds are both a sucker’s bet. As an investor, the best thing you can do to profit from these “alternative” investments is to avoid them altogether.
While I realize this isn’t a widely held viewpoint, it is one that’s gaining support. Just ask “perma-bear” Jeremy Grantham, the Boston-based money manager who supervises $150 billion in investments for Grantham, Mayo, Van Otterloo & Co. LLC. In an interview published earlier this week, the 68-year-old industry veteran predicted that the spiraling credit crunch could cause half of all existing hedge funds to close within five years.
Hedge funds “are piling on risks of different kinds and presenting it as out performance,” Grantham told Bloomberg News. “In a weak world [made weaker by a credit crunch], they pay the price of all the risk they’ve taken …they melt down.”
Indeed, the meltdown has already started.
Two hedge funds operated by investment bank Bear Stearns – wiped out when they made a big bet on the now-highly troubled sub prime mortgage market – filed for bankruptcy protection yesterday (Wednesday), while the assets of a third were frozen by the company (for a more-detailed report on Bear Stearns’ hedge fund woes, click here).
In today’s global capital markets, havoc can be wreaked in a flash. On Monday, Hedge fund Sowood Capital – which managed an unspecified portion of Harvard University’s $30 billion endowment – revealed it would shut down after a month in which lousy bond-market bets vaporized half its assets. In less than four weeks, Sowood reportedly saw its assets plunge from $3 billion to about $1.5 billion. To save what was left, the firm sold out to Citadel Investments Group, a hedge fund operator that manages assets of about $14 billion. It was Citadel that stepped in to rescue the energy portfolio of failed hedged fund Amaranth Advisors last year.
The Basics: Hedge Funds Math
If your broker hasn’t tried to talk you into investing in hedge funds, yet – and you have more than $1 million in “investable” assets – don’t worry, he soon will. After all, this is now a $2.4 trillion investment pool, and as you’ll soon see, your broker has a huge incentive to bring you into the fold.
He’ll probably call them “uncorrelated assets,” and will explain that their returns have very little to do with the general performance of the major U.S. stock indexes. For that reason alone – to “protect” a portion of your assets from any domestic-market nastiness – you really had to become a hedge fund investor.
But no matter what your broker might try and tell you about the hedge funds he’d like you to invest in, the reality is this: Since this type of fund is so profitable for the management group that runs them because of the hefty fees they’re able to charge, it should also be clear that they are quite profitable for the brokers who sell them. So you needn’t worry that you might be missing out on a truly exciting investment opportunity.
The term “hedge fund,” itself, is really quite a misnomer: Unlike an options-oriented “hedging” strategy that a company or a sophisticated individual investor will employ to protect their investments against a market downturn, hedge funds really don’t offer the same counter-balancing bets.
The truth is that the term “hedge fund” is used as a kind of loophole. It distinguishes them from such retail offerings as mutual funds, which are open to most all retail investors, which are therefore heavily regulated as a result. Hedge funds are only open to qualified, or “accredited” investors, most of them wealthy. Thanks to this limited potential audience, hedge funds are largely free of direct oversight by regulatory authorities, and can operate in a great deal of secrecy. They are free to charge large performance fees, and can utilize strategies that are much more complex and often take on much greater risk than the mutual funds most retail investors are familiar with.
But the biggest secret of all – and one that your broker almost definitely won’t reveal to you – is that the average hedge fund return isn’t very exciting: It was just under 12% in 2006, and was only 4.5% in the four months to April 2007, according to one report. By comparison, the Standard & Poor’s 500 Index returned 15.8% for all last year, and was up 5.1% in the first four months of this year.
However, due to a factor known as “survivorship bias,” the “real” hedge-fund results are probably actually much worse than most research shows. You see, hedge funds that disappear during the year – logically speaking, the worst-performers of the lot – are taken out of the results, a fact that very likely skews the results and makes them appear much better than they actually are.
Barclays Capital has calculated that hedge fund returns are overstated by as much as 2.4% per year, which takes the forecasted 12% return all the way down to 9.6%. Now go in and subtract the 2% management fee and a 20% performance fee (20% of the 9.6% average hedge fund return), and you’re down to 5.7%.
Now get this: Because of the way those management performance fees are calculated – that 20% management fee isn’t refunded on losers – even the average annual return of 5.7% that we’ve cited here is far too high.
Look at it this way. Let’s say that you’ve made equal investments in three hedge funds that as a group have generated an average annual return of 9.6%. But one fund returned 50%, the second 28.8%, and the third lost 50% of its principal value (the average of which is 9.6%). You might just think that the management fee on an equal investment in all three funds would be 20% of the 9.6% average return, or 1.92% (20% x 9.6% return = 1.92% performance fee for the fund managers). But it doesn’t work that way.
Instead, your management-fee charge for your investment in the three funds would look more like this. You’d pay 20% of (50%/3 funds) plus 20% of (28.8%/3 funds), or 5.25%. And that knocks your net overall return down to 2.35% – quite a difference from the 12% that you foolishly might have been anticipating.
To pretty it up and make it look all the more attractive, brokers will often quote you the so-called “top-quartile” investment return. That’s the return made by the top 25% of all funds. If you invested at random, you would have had a 25% chance of achieving this performance. The broker may even compare this top quartile figure to the top quartile return generated by conventional mutual funds.
This is the stockbroker’s version of a “carny” trick. He does this because hedge funds invest in such a wide variety of different things that their returns have more “dispersion” than stock funds – in plain English, they’re riskier – so that the top quartile is further above the median for hedge funds than for stock funds.
The Problem With Private Equity
As an alternative to a “hedge fund” your broker may try to get you to invest in a “private equity fund.” These don’t invest all over the place, like hedge funds, but instead buy whole companies, “improve” their operations and sell them again. Private equity funds have one advantage over hedge funds and two disadvantages. The advantage is you have a rough idea of what they are doing: Their strategy isn’t secreted away in a so-called “black box” that’s filled with incomprehensible, pseudo-mathematical jargon.
One disadvantage is that to return a profit they must either sell the company they’ve bought on the stock market via an Initial Public Offering (IPO) of stock, or to other companies whose shares are listed on the stock exchange. That means that these funds are also not really “uncorrelated” investments, as they so often claim private equity funds to be. And in a bad market – such as the downturn of 2001-2002 – they can do appallingly badly.
The other disadvantage is that, as well as benefiting from the same “20% for us if we win, nothing for you if we lose” fee structure of hedge funds, private-equity fund managers are rewarded with performance bonuses that are based on the value they’ve added to the companies they’ve acquired with the intention of later selling.
To assess this, the fund managers hire “tame” accountants as business-valuation consultants, and then ask these advisors to estimate the company’s value. Since the accountant’s fee is based on the value of the company, he’s got a real incentive to make and justify a very high estimated value. Management gets paid its performance bonus based on that estimate. So even if the company ends up selling for a lot less – even at a breakeven price, or still worse a loss – management has already been paid. So even when private-equity-fund investors don’t receive any money, the fund’s managers still win.
As an avid Red Sox fan, I have been heartened by the team’s renaissance in recent years, a turnaround fueled by the untold billions of their new principal owner, John Henry, a hedge fund mogul who bought the team in 2002. He’s rich like New York Yankees owner George Steinbrenner. But because Henry made his fortune via hedge funds – while “The Boss” inherited his (thanks to a shipbuilding company) – we BoSox fans like to think that John is smarter than George.
But there’s one flaw in that logic. As the title to Fred Schwed’s 1940 investment classic asked: “Where are the customers’ yachts?”
Since December 2004, two months after the Red Sox exorcised the “Curse of the Bambino” and won their first World Series since 1918, Henry’s funds are down more than 35%. What’s more, over the last decade you would have done better buying an index fund or investing in Treasury bonds than investing in Henry’s funds. For this service, Henry charges the usual hedge fund fees of 2% of assets under management, plus 20% of the profits – indeed he is sometimes credited with inventing that typical hedge fund fee structure.
This is, of course, bad news for the Red Sox: Brett Arends, of TheStreet.com, recently said that Henry’s assets under management had declined from $2.9 billion to $1.4 billion, so there may well be no more $103 million Japanese pitchers in the team’s future. However it’s even worse news for Henry’s investors, particularly those who bought in 2004, when performance really started to decay.
In short, hedge funds and private equity funds are both a mug’s game and should be avoided.
If you want “uncorrelated assets” you should look at some top-quality stocks from some of the Asian markets that are still trading at very reasonable levels: Such countries as Japan, Korea and Taiwan haven’t seen their indices streak into record territories, and are not trading at the same pricey levels as their U.S. rival.
It’s true that their returns are not completely uncorrelated with the U.S. markets, because today’s global money market is just one gigantic muddy pool. But my very detailed research shows that at least the domestic economic situations in these three countries – as well as the political factors that affect them – are very different than those facing the United States.
As for private equity funds, they are a good investment only in the depths of the most-terrible markets – like in the late 1970s and early 1980s, when stocks were so disdained that Business Week magazine actually carried its now-famous cover story, “The Death of Equities.” It’s during those periods that you’ll find lots of companies available at very cheap prices. But, of course, we are nowhere near that state at present.
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