Hedge Fund Headache
from
September/October 2006
by John J. Curran
For high-net-worth investors, the hedge fund craze of recent years is tantamount to a religious frenzy, and no wonder. With returns like the 140% logged by the Goldman Sachs Alpha fund in 2004, who wants to waste time with mutual funds? Hedge funds haven’t been an asset class so much as a money miracle.
Problem is, those heavenly returns have fallen to earth with a thud. As money poured into hedge funds—some $120 billion during 2004 and 2005, according to Hedge Fund Research in Chicago—the returns have all but disappeared. Why? In large part, hedge funds are a victim of their own success. The whole idea behind them is that they are free to exploit market inefficiencies, whether these exist in the general market, in distressed securities, or on either side of a merger. But such opportunities, while rich indeed for the savvy trader, are finite, and the more money that is devoted to exploiting them, the smaller the payoff is likely to be.
As the table below plainly shows, returns from four major groups of hedge funds have averaged no better than the typical bond mutual fund over the past two years. Of course, there’s one big difference: Unlike mutual fund companies, hedge fund managers take outsize fees, starting with a Doberman-size bite out of assets of 1% to 2% each year. Many hedge fund investors pay yet another fee, because some 40% of the money flowing into hedge funds arrives via a fund of funds. That’s an arrangement in which an über money manager takes an added fee to direct money to specific hedge funds, lowering the return still more. And if the fund is above its so-called high-water mark, or the highest net asset value it has attained in the past, managers also get a generous 20% cut of profits.
It’s not just the nominal returns that are discouraging. Analysts at Russell Investment Group contend that many of the higher performers of late owe much of their oomph to, gulp, leverage, not investing talent. “Alpha [the excess return beyond what a passive investing strategy would produce] has been declining for the past few years,” notes Russell’s Steve Wood. The negative trends prompted the wealth-management team at Bernstein Investment Research & Management to get blunt with its clients in a recent written report: “Many hedge fund managers will wince at this thought, but you’ll likely do better in the years ahead with a more conservative investment posture.”
| Returns are Clipped | ||||
| Fund Category |
Total return to investors
|
|||
|
2003
|
2004
|
2005
|
2006 through June
|
|
| Global Hedge Fund Index |
13.39%
|
2.69%
|
2.72%
|
1.1%
|
| Absolute Return Index |
11.95%
|
3.20%
|
-0.02%
|
2.1%
|
| Market Directional Index |
25.22%
|
4.84%
|
4.20%
|
1.1%
|
The Global Hedge Fund Index represents the overall composition of the hedge fund universe. The Absolute Return Index represents funds that seek stable performance regardless of market conditions; the Market Directional Index represents funds that add value by participating in and betting on market moves.
