Hedge Funds Are Bad Investments, and Here’s Why

In my former life as a hedge fund analyst, it was my job to find good hedge funds and recommend them to the firm’s clients. We looked for trustworthy hedge funds across a variety of strategies, which would have steady, positive performance. Despite the team all having studied economics and gaining the requisite industry qualifications like CFA, CAIA, and FRM, over the course of around 15 years the team managed to generate returns of a little over 4% per year, with volatility of around 8%.

Now let’s be honest, that’s pretty crap. And what’s more, that actually overstates the money made by our clients.

So why are hedge funds such a bad investment?

One of the main reasons hedge funds look bad is that people who tend to invest in hedge funds are just bad investors. Most investors like to see a good track record before giving their money to a manager, so what often happens is they will pile into a hedge fund that has just had a good year. Unfortunately, hedge funds tend to perform badly when they get too large. John Paulson is a prime example of this. After becoming famous in 2008 by a well-timed bet on the subprime crisis, his funds swelled right before suffering crushing losses (with one fund losing over half of it’s value). John Paulson has now lost far more money than he has ever made, or ever will make. Great job!

Hedge Fund Manager John Paulson

It is important to know the difference between time-weighted and dollar-weighted returns in this respect. If a hedge fund returns 10% per year for 9 years, then loses 10% in the tenth year, the overall returns are still pretty good for someone invested for the full 10 years. On a time-weighted basis the returns are fine. However, there is often very little money in the fund for the early years, and a lot of money in the fund in later years. This means that the -10% loss in the final year actually loses more money than all the combined 10% yearly gains earlier. This means that the returns on a dollar-weighted basis are negative. The result is that most investors in hedge funds actually end up not making the returns quoted by the hedge fund in their marketing literature.

Another reason that hedge funds are not a good investment is that the hedge fund fee structure is biased against investors. In his book The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to Be True Simon Lack illustrates the outrageous nature of the hedge fund industry’s fee structure. He calculates that the real profits made by investors in hedge funds between 1998 and 2010 amount to $9 billion, whereas the fees made by the managers amount to $440 billion. Part of the problem is that while the fund takes 20% of all your profits, it doesn’t refund you these fees if it then loses your money. It’s a great set-up for the hedge fund manager – he takes your money when returns are positive, and then keeps it when returns are negative. Another problem is that if you invest in a few different hedge funds, you are subject to netting risk. If you put $1 million into two different hedge funds and one goes up by 10% and other goes down by 10%, you end up with an overall return of 0%. However, you are paying 2% fees on both funds, and you are also paying away 20% of your profits on the fund that increased in value.

Now let’s make the situation worse. Imagine that you are investing in these hedge funds via a fund-of-funds. These guys will take an additional 1% fee and 10% of any profits made.

A final reason for hedge fund underperformance is simply that hedge fund managers have gotten worse as the industry has grown too large. This has hurt performance in two ways. Firstly, there are now a lot of managers who simply aren’t that good. Secondly, if alpha is a scarce resource, there are now too many dollars chasing the same finite market inefficiencies.

The key takeaway is that any hedge fund investor is starting with a huge handicap due to the hedge fund industry’s standard fee structure of 2 and 20 (2% annual fee followed by 20% of any profits). Investing is tough enough already when you have to interview fund managers to determine if they are a fraud. Even if they are trustworthy and capable of generating consistent positive returns, you start with a significant disadvantage.

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