Every so often, people start questioning whether hedge funds are really the best investment vehicle out there, as their high fees imply.Today both Chris Douglas from Morningstar and Chris Hutchinson, the co-author of Alchemists of Loss: How Modern Finance and Government Intervention Crashed the Financial System, make the argument that hedge funds have only succeeded in recent years because of great marketing, and the availability of excessive leverage funded by over-expansionary monetary policies since 1995.
The timing is perfect. Tons of big name hedge funds are getting slammed with bad returns in August.
Hutchinson says investors will see more of this in the future because the age of the great hedge fund is over. He writes in Asia Times:
“It is not surprising that they have sprouted like weeds in the prolonged easy-money period since former Federal Reserve chairman Alan Greenspan’s monumental policy error of February 1995. In the years to come, the piper will have to be paid through higher interest rates, to rebuild America’s depleted savings base and to wring inflation out of the system.”
Douglas is worried it’s just beginning, because investors are increasingly being lured by false promises in the hedge fund marketing strategy, “absolute return.” He says the trend is now picking up steam with institutional and retail investors, not just high net worth individuals. He writes in Asian Investor:
Institutional demand can be seen from the fact that the hedge fund sector attracted $116.2 billion globally in the first six months of 2011 – the strongest half-year asset flow on record, according to data provider Eurekahedge. Further, since the end of 2008, more than 700 absolute return funds have been launched (primarily targeting retail and high-net-worth investors) and this trend is gathering pace.
Both use arguments against hedge funds we’ve heard before:
- Investors chose strategies for the wrong reasons. Douglas points out that after the Black Monday stock market crash of 1987, absolute return-style strategies became all the rage, too.
- The “survivorship bias” is huge. Unsuccessful hedge fund managers have little money or power, and both they and the industry in general have every interest in suppressing knowledge of their failures rather than publicizing it, writes Hutchinson.
- Their advantage is marketing to wealthy individuals. They can be played on with the same snobbery techniques applied to merely affluent individuals (the “profits secret Wall Street won’t tell you about”). And institutional investors are managed by affluent individuals subject to the same sales techniques.
- In general, their returns are not great. Hedge funds returned only 10.87% in 2010, compared to a return on the S&P 500 (available even to the plebs through the Vanguard 500 Fund) of 30.84%. In the first six months of 2011, hedge funds have made a return of only 0.42%, compared to an S&P 500 return of 6.02%, according to HedgeFundNet.
Hutchinson predicts that when the era of easy money comes to an end, so will hedge funds.
Wealthy individuals and institutions [will] come to their senses and realise that by incurring exorbitant costs on the management of their money they are assured only of the exorbitant costs, and not of superior investment returns.
But besides gambling or making your own money, no one has been able to offer high returns on investment like some of the big names have made for their investors year after year. If you stayed invested in Paul Tudor Jones’ fund Tudor Investment from 1986 through last summer, for example, your investment made over 20% annualized returns. If you had invested in Steve Cohen’s SAC Capital in 1996-2009, your money gained 27.1%.
Also, the year John Paulson made some of his investors billionaires while the rest of the world lost their savings was only three years ago. Even with returns as low as -40%, he’s doing OK. In fact he recently started offering his fund to more “regular” investors because there is that much demand. And if Asia (where both of these guys write from) doesn’t blow up, there’s a whole slew of new demand right there. Hedge fund marketing might even work even better over there. The boom is here to stay.