Photo: CNBC screenshot
My industry colleague Simon Lack has recently been demonizing hedge funds with a recently published book and ongoing blog campaign. Recently, he called the idea of a diversified hedge fund portfolio “stupid,” a comment I simply cannot take sitting down. To claim that investing in a diversified basket of hedge funds is no better than investing in passively managed combination of indexed equities and Treasury bills is not only irresponsible, but is cherry picking at its worst. Mr. Lack should know this as a registered investment advisor.
As an investor in hedge fund portfolios myself, I too agree that diversification solely for the sake of diversification is ill-advised. In the industry we call this “di-WORSE-ification.” Savvy hedge fund investors will not allocate to a fund without thorough due diligence or understanding the nature and methodology of how the returns will be created. Active portfolio allocators will know when to shift from managers and strategies that are lagging or topping off into those with more upside. Over a full investment cycle, a hedge fund portfolio will include exposure to many strategies, including long/short equity, distressed credit, mortgages, global macro, etc…
People and organisations invest in hedge funds for a number of reasons. These include downside protection against equity bear markets and reducing overall portfolio risk, the opportunity to invest in strategies that offer better risk/return profiles but cannot be replicated by mutual funds or ETFs, as well as adding a non-correlated return enhancer for their overall portfolio. This is especially true for pension funds looking to fill funding gaps in their future liabilities.
A recent study co-authored by the Alternative Investment Management Association (AIMA), accounting firm KPMG, and Imperial College, London showed that hedge funds returned 9% annually net of fees over the last 17 years. This is significant outperformance of traditional asset classes over that time period, according to the report. The research also shows that a 60/40 stock/bond portfolio may well have done better than hedge funds in recent years, but an equally split hedge fund, stock and bond portfolio would have done the best. You can download the report for yourself here.
Mr. Lack also likes to reference this juicy tidbit from his book: if all the money ever invested in hedge funds had been in treasury bills instead, the investors would have been better off. However, a recent article in the Financial Times noted the following mischaracterization by Mr. Lack of hedge fund returns:
Mr. Lack says hedge fund managers earned an estimated $379bn in fees between 1998 and 2008, out of total investment gains (before fees) of $449bn, meaning that investors received only $70bn. However, those figures are returns above US Treasuries, not actual returns. If you look at the actual returns the figures are dramatically different. For example, Rick Sopher of LCH Investments (an investor in hedge funds) has estimated that the industry has returned $557bn to investors since inception.
Finally, the cynic in me reads beyond the catchy headlines to see that Mr. Lack’s firm manages all of$8 million, a number I’m sure he would like increase with all this newfound attention he is getting. Here’s the best part… his firm offers a long/short equity strategy.