Hedge Funds: The Emperor’s New Clothes?

Brett Arends recently wrote a piece for MarketWatch in which he expressed the opinion that hedge funds are a sucker’s bet.  He bases his argument on a fascinating  study called Higher Risk, Lower Returns: What Hedge Fund Investors Really Earn that was published in 2009.  The authors of the study, professors from Emory University and Harvard, came to the conclusion that hedge fund investors would have (on average) been better off buying an S&P500 Index fund. So, if hedge funds have performed as badly as this academic study suggests, why have assets invested in hedge funds skyrocketed over the past 20 years?  As the authors themselves point out, assets in hedge funds went from $38 Billion in 1990 to about $2 Trillion in 2011. Here’s why. Increasingly, large pension plansare putting assets into hedge funds.

Taking a Gamble on Hedge Funds

A simple explanation, of course, is that investors put their money into hedge funds for the same reason that they gamble in Las Vegas or buy lottery tickets.  Everyone dreams of the big win and hedge funds provide this sort of potential (and the associated bragging rights). Another explanation is that many investors (including institutional investors)  want to believe that there’s  some magic formula that will make them enormous returns with little risk.  There also seems to be a ‘herding’ mentality associated with hedge funds (as we saw with Bernie Madoff).  People felt confident putting their money with Madoff because their brother-in-law, co-worker or old college roommate (supposedly) invests with him.

Hedge Funds: Not a good deal for the Individual Investor

There are some very smart people who invest large amounts of the money successfully in hedge funds.  David Swensen, manager of Yale’s highly successful endowment,  has delivered a long track record of high returns using a strategy in which hedge funds play a substantial role.  But even the ‘Yale Model’ looked a lot less attractive  after the market crash of 2009 when the endowment lost almost 25% in its  fiscal year (ending June 2009).  This loss notwithstanding, the ten-year returns for Yale’s endowment through their fiscal year 2010 averaged 8.9%. Even though Swensen has used hedge funds as part of a successful investment strategy, he does not believe that individual investors should be playing in this arena. In fact, he  specifically discourages individuals from doing anything more exotic than investing in a diversified basket of index funds.

So, where does this leave us?  For the vast majority of investors, the issue is moot point. Most investors simply don’t have enough in assets that would allow them to invest in hedge funds.  Even for those with the required net worth, many hedge funds set investment minimums and other restrictions that are prohibitive.  The research study cited above suggests that the average returns from hedge funds are unattractive anyway.  For hedge fund investors to be successful, they need to be sophisticated in selecting where to put their money–and this is one of Swensen’s key points.  He believes that Yale is successful in this arena because he and his team are specially qualified to identify the best managers.

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