Its hard to pick up a financial newspaper these days
without seeing some sort of piece on a purported hedge fund
disaster. There are a number of reasons, I surmise, that this
is the case:
The rich guy gets hammered trope sells
papers. For every fund down 20 percent, a different
one is up 20 percent. Theres a cottage industry of people
who run around trying to find the next calamity.
High fees justifiably lead to high
expectations. When you pay 2-and-20, you should expect
magic. Reveal the wizard as human, and disappointment and anger
Zero-interest rates make high-fee strategies look
terrible. Cash plus 4 percent with bondlike volatility
and low correlation to traditional assets is a valuable
diversifier. The problem is that today cash plus 4 percent is
only 4 percent. That seems pretty paltry after youve paid
3 percent or more in fees.
Bull market equity returns are a terrible point of
comparison. The next 30 percent-plus drawdown in
equities will be a great equalizer across strategies.
Procrastination has paid off handsomely.
Many articles miss the point.
CalPERS pulled out from hedge funds because $4 billion
didnt move the needle on $325 billion in assets. MetLife
cut back on its hedge fund allocation because it prefers
private equity whose fees are higher than hedge
funds where it doesnt have to mark the
portfolio to market. The ballyhooed $15 billion pulled from
hedge funds during the first quarter of this year was half of 1
percent of the industrys $3 trillion in assets
hardly a flood of redemptions.
Lets do a reality check. Hedge funds have set
themselves a difficult task: to generate equitylike returns
with bondlike risk. In simple terms equities have a 5 to 6
percent return over cash over time, with 15 to 18 percent
volatility. For statistics aficionados, this is a
Sharpe ratio of around 0.3. Bonds have returned cash plus 2
to 3 percent with half the volatility again, a Sharpe
ratio of about 0.3. Hedge funds are trying to do cash plus 5 to
6 percent with volatility of 6 to 8 percent or double
the Sharpe ratio. If they can do that consistently, then any
associated headaches such as illiquidity, high fees or opacity
are worth it.
Now lets turn to a set of well-founded criticisms:
Hedge funds have underperformed their own
expectations. Over the past ten years, the HFRI Fund
Weighted Composite Index has returned 2.6 percent over Libor.
Decent, but hardly worthy of a victory lap. Funds of funds,
with another layer of fees, have done much worse.
Hedge fund fees are probably double what they should
be. Before fees, funds typically hit their target of
Libor plus 5 percent with a Sharpe ratio of 0.8. The problem is
that virtually all that value-add goes to the managers.
The allocation process is broken. All the
money goes to the largest managers to cover themselves rather
than for investment reasons. The story line of a fund
puts up great numbers when small, then pulls in a ton of money
and cant repeat it is played out day in and day out
across the industry.
Some strategies are worth the fees, and others
arent. The decline of market-beating returns in
equity long-short strategies means investors regularly overpay.
For other tactics, such as illiquid or esoteric strategies,
its a different story, however.
Some populism is warranted. Persistent
overpayment by pension funds comes off as unseemly. On big
dollars, saving a percentage point or two in fees makes a real
difference to retirees.
Instead of throwing out the baby with the bathwater, pension
fund trustees should demand that their advisers provide a clear
justification of when high-cost strategies are warranted and
when theyre not. Hope isnt an excuse anymore. They
should be attuned to the fact that advisers almost invariably
allocate to managers who have done well which garners
few complaints. This is simple selection bias, and its
pervasive throughout the industry.
Advisers should also be required to explain why high-fee
asset classes are preferable to lower-cost ones, such as
multiasset strategies that, like hedge funds, seek to
return Libor plus 5 percent with controlled risk but charge a
quarter of the fees.
Advisers should be held to the same alignment and
performance standards that are applied to active managers.
Examine their picks from three years ago: Did they meet the
assumptions established at the time? If not, why? Its too
easy to move the goalposts or blame the markets.
The tools are there; investors just need to use them.
Andrew Beer is managing partner and coportfolio
manager at Beachhead Capital Management, a hedge fund
advisory firm, in New York.
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