The great hedge fund con

Hedge funds are meant to be masters of the financial universe. But their returns have been nothing short of pitiful. The truth is, it’s a racket, pure and simple, says Tom Bulford.

According to The Economist, the average hedge fund recorded a gain of 3% last year – miles below the 13% rise in the global equity market. Not very impressive! But the long-term statistics gathered by Hedge Fund Research are even worse.

They show that the total return delivered by hedge funds over the past decade is a feeble 17%, equivalent to barely 1.5% per year. As the Economist points out, this compares to the 90% return that a ‘simple-minded investment portfolio’ of 60% shares and 40% sovereign bonds would have produced. For that matter it is also less than would have been produced by simply plonking the money in the bank and forgetting about it.

The apparent masters of the universe

To call the performance of hedge funds disappointing is an understatement. Hedge fund managers are supposed to be masters of the universe. Super-bright and armed with the latest technological wizardry they are, we are led to believe, far too smart to be confined within old fashioned investment houses.

Allowed to roam free across the whole universe of financial instruments, they are supposed to be able to spot trends before the rest of us and capitalise on market anomalies that mere mortals cannot discern.

For this they have charged a 2% management fee, plus 20% of any profits. An arrangement that looked hugely biased in their favour when hedge funds were launching in their droves over a decade ago, and now looks simply monstrous.

This is a racket, pure and simple, and it has never fooled me. But is has fooled many who should know better. You might think that investors in hedge funds are the super-rich, those with more money than sense and deserving of little sympathy.

But in fact, two-thirds of the assets under hedge fund management come from pension, charitable and other such institutional funds. In other words, this is our money, and thanks to decisions made by the people who oversee these funds, we have all lost billions while hedge fund managers have made a fortune.

 

Trading is just gambling

I think this is a real scandal. Institutional funds have boards of trustees whose job it is to determine asset allocation and to appoint fund managers. In this they are advised by investment consultants, armed with data based on historic returns and a lot of mumbo-jumbo about risk management.

I say ‘advised’ but I probably should say ‘led by the nose’ because these trustees, who flatter themselves that they have wisdom and sound judgement, are in fact terrified of falling out of line with their peer group. They lap up the hopeless advice of the consultants without having the wit to question it, and fall for all of the marketing of the hedge fund industry.

Let me make it clear. Hedge funds are traders. Traders simply try to make money at the expense of others. Trading is a zero sum game. The hedge fund racket was never going to work. It was doomed to failure, and the larger it became the quicker this would inevitably become apparent.

Trading and investment are two totally different things. Trading is just gambling. Investment means putting your money to work in enterprises that will earn a high return on capital over a number of years. It beggars belief that trustees of institutional funds cannot understand this simple distinction.

Lasting returns come from wealth creating enterprises

Of course, they’re not going to kill the goose that lays the golden egg if they can help it. They say that while the average return of hedge funds might be moderate, some have done very well – a non-argument, as far as I am concerned. They argue that they can borrow money to ‘leverage’ returns and that, of course, can work both ways. But the big argument for hedge funds is one that really makes me mad.

Hedge funds, they say, “reduce risk by providing diversification”. By this they mean “reduce volatility” – but you could achieve this by sticking a part of your money under the mattress. It would do nothing to improve your investment returns.

Dozy fund trustees must now be finally cottoning on to the fact that they have been paying huge fees for hyperactive investment and getting minimal returns. So what will happen next? Those slippery investment consultants will tell them that low cost tracker funds have beaten the active hedge funds. So they will all pile into index trackers, and this will become the next overrated investment fad.

One day fund trustees and investment consultants might understand that real lasting returns come from investment in wealth-creating enterprises and not from trading or artificial constructs of the ever creative financial services industry. But I am not holding my breath….

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