“To the point: Hedge funds have no science but to bet on heads or tails”

By: Edmond Warner, Daily Telegraph
Published: February 1, 2007

This article suggests that hedge funds, under pressure to perform, are simply levering-up 50/50 (”fair”) bets.  According to its author, hedge funds use “pseudo-scientific investment models that are no more than cottage industry gambles”. Unfortunately, he dredges up tired stereotypes as proof and neglects to back them up with any applicable facts.  So as a public service, we put this article into our “B.S.” detector to see what would come out the other end.

“(hedge fund) fees dwarf those paid to conventional money managers”

As we have discussed several times (here, here, here, here & here), one cannot look solely at a fund’s sticker price to determine its value.  Long-only funds have lower sticker prices because many of them are closet index funds.  And index funds have a low fee for a reason – there is very little work involved.

“As with all things in the great capitalist machine, the laws of supply and demand were at work.  Initially, the number of hedge funds was small…There was no incentive for hedge fund managers to compete with each other on fee rates.”

As the article itself goes on to complain, fees have not changed since these early days.  So the “initially” high fees to which the author refers were apparently not the result of short supply after all.

“Most hedge managers were smart enough to realise that their exotic investment processes would suffer if too much money were thrown at them.”

There is a lot of mythology surrounding the notion that most hedge fund managers close to new investors to protect their ability to generate returns.  From our experience selling hedge funds to global institutional clients, this was not usually the case – although it makes a great marketing story.  (Academic research also shows that the industry-wide capacity constraints are an urban legend for most hedge fund strategies).

“Although hedge fund performance has worsened, appetite for investment in them has not slackened.”

What remains unsaid here is that fees should fall, but don’t.  But fees have fallen.  Most of a hedge fund manager’s compansation is dependent on the performance of the fund.  Thus, if the fund’s performance falls, so does the manager’s fee.  If we should be complaining about anyone, it’s the mutual fund industry.  Their fees stay the same no matter how low (even negative) their returns.  During flat years, their fees might engulf the lion’s share of gross returns.

And a real humdinger to top it all off…

“hedge funds are resorting to reckless gambles in the pursuit of success…Last week I was told the tale of a hedge fund manager’s 35pc fund growth last year. He was modest enough to deflect the praise with the confession that his underlying investments only rose 7pc, but that five-fold leverage accounted for his stellar headline figure.”

Perhaps this manager cited in this article was reckless – especially if the underlying positions were simply long equity positions.  But it’s impossible to judge recklessness based solely on leverage.  What if the “underlying investments” were low volatility arbitrage trades?  Indeed, what if they were commodity trades – which are routinely leveraged due to the use of futures contracts?  Should we also avoid companies with more leverage on their balance sheets?

Hedge funds just flipping a coin? To be sure, when you really get into the data on the hedge fund industry (as have many academics such as David Hsieh, Harry Kat, Andrew Lo, Narayan Naik, & Francois-Serge Lhabitant) you will find some ”fair bets”, but these bear little resemblance to simple coin-tosses.  (For example these bets might involve ”alternative” risk factors, rules-based trading of traditional risk factors, or flat-out timing of these risk factors.)  But to suggest that hedge funds are simply glorified coin-tossers is blatant populism.

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