A few years ago advisory firms faced an uphill battle trying to convince investors to add hedge fund exposure to their portfolios. Today the problem is almost the opposite—when an advisor first encounters new clients they are as likely to have too much hedge fund exposure (or the wrong kind of exposure) as to have not enough. Whether investors are drawn to hedge funds for their return potential, whether they are fleeing debacles in other capital markets or whether they are simply seeking prudent diversification, the problems today are too much haste, too little caution, and diligence that is too superficial.
Probably the main challenge for investors in hedge funds going forward is the one just mentioned: the popularity of hedge fund investing. The more money that pours into a sector, the more difficult it will be for managers to add value. Vendors in the hedge fund business will argue that, though some strategies are naturally capacity constrained—merger arbitrage, for example—others are not. Long/short equity managers and fixed-income arbitrage managers play in markets that are measured in the trillions of dollars. Hence, so the argument goes, even a manager with several billion dollars under management will represent only a tiny drop in the vast ocean of opportunities.
But this is the wrong measure. In U.S. large caps, the question isn't whether or not any individual manager has a lot or a little money to work with. The question is how much money, and how many players, are at work in the sector. As more and more managers engage in long/short equity or fixed-income arbitrage, the information available to everyone in those sectors will expand, leaving even talented managers with little room to run.
More broadly, we should assume that all alpha-based strategies are inherently capacity constrained. The most talented managers may develop many more good ideas than less talented managers, but less talented managers are exceptionally good at copying successful strategies. Hence, as more and more players enter a field, the half-life of good ideas declines precipitously. In addition, although there may be trillions of dollars invested in global equities and fixed income, the subset of those markets that have value to be exploited is far, far smaller. Managers who identify value and act on it will find that their activities are much more conspicuous than we would imagine if we think only about the aggregate size of the equity and bond markets.
Let's examine some other challenges faced by prospective investors in hedge funds.
Survivorship bias. Earlier, I cited the extraordinary returns achieved by hedge funds over the past 10 years. But that data is highly suspicious, not least of all because of the phenomenon of survivorship bias. This phrase refers to the fact that only the most successful hedge fund managers have survived for the 10-year period we are measuring. Less-successful managers long ago went out of business, and their demise has imposed a kind of double-whammy on reported returns. First, because they are no longer in business and reporting their results, the (poor) performance of failed managers has been removed from the historical record, dramatically raising the reported performance of the surviving managers. Second, because they are no longer managing money, failed managers are no longer turning in those lousy returns, which would continue to bring down the averages. In other words, the actual returns achieved by investors in hedge funds over the past 10 years are far lower than the actual returns achieved by the surviving managers over that period. In the Lake Wobegon world of hedge funds, all managers are above average.
Volatility and risk. When investors and their advisors design portfolios, they tend to use volatility as a proxy for risk. But in the hedge fund world, price volatility does not capture anything like all the risks embedded in the sector. Specifically, volatility ignores the liquidity risk inherent in hedge fund investing, as well as the risk of fraud or other misconduct. Most hedge funds offer only quarterly liquidity, though some impose one-year lockups or even longer. For an investor who needs or wants cash, even a quarter can be an eternity. Fraud, although rare, is hardly unknown among hedge fund managers, and when it happens, the consequences for investors in the affected funds can be truly disastrous. The long and short of this is that investors who look only at hedge fund volatility in designing their portfolios will almost certainly end up with an overexposure to the sector: The apparently attractive combination of low risk (volatility) and high returns will cause hedge funds to dominate the optimizer, resulting in “optimal” hedge fund exposures that are far higher than is prudent.
Skewness and kurtosis. As noted above, most hedge funds do not constitute a separate asset class—they simply represent an alpha strategy. Hence, the use of traditional modern portfolio theory tools to design hedge fund portfolios (standard deviation, correlation, expected return) simply will not work. The problem, in technical terms, is that the hedge fund world is characterized by skewness and kurtosis. Translated into English, this means that (a) hedge fund returns don't occur in a normal, bell-shaped distribution the way returns occur in equity markets, and (b) the likelihood of very bad outcomes is very high. Among other things, hedge funds occasionally blow up for all sorts of reasons, resulting in the loss of all or most of the fund investors' capital. But it is also important to keep in mind that, although adding hedge funds to a traditional portfolio will typically reduce the dispersion of outcomes, it will also increase the likelihood of a negative outcome.
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A diluted manager talent pool. Fifteen years ago only the most talented managers could hope to be successful in raising money for a hedge fund. These days, however, there is so much demand for hedge fund exposure that it seems as though anyone with a high school diploma can successfully set up a hedge fund. Many newer hedge fund managers do not even have investment track records—they may have been financial analysts, for example. Even those with direct investment experience often have no experience selling stocks short or employing other hedging strategies. Short selling is a nerve-racking activity in which potential losses are unlimited and potential gains limited. Other problems with new managers include inexperience managing their own businesses and inexperience managing complex back-office challenges.
Too much capital coming into the business. Very few investment strategies can preserve returns when massive amounts of capital pour into the business, and hedge fund investing is no exception. Some of the new capital in the hedge fund world emanates from investors who are thoughtful and experienced, but who must invest so much capital (in order to have any impact on the returns in their gigantic portfolios) that they simply cannot do a good job of putting the money to work. Other capital is coming from sources that have precious little experience investing in hedge funds and who are proceeding with such undue haste that it is clear they are simply exploiting the public's sudden appetite for hedge exposure. A particularly worrisome development involves the advent of so-called “capital guaranteed” products. Many European banks (and, recently, some American banks) have raised large amounts of capital from inexperienced investors via this tactic, under which the financial institution guarantees investors that they will not lose money in hedge funds if they keep their money invested for some minimum period of time, usually five or six years. Other structured products—typically levered—are also being offered, as well as the retail products described earlier.
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Tax inefficiency. For taxable investors, this may be the biggest issue of all: The gross returns of hedge funds have to be adjusted for their tax inefficiency. And note that this inefficiency can be huge, because, for most funds, almost all the return is generated in the form of short-term capital gains and ordinary income.
12 There are techniques that can be used to shelter hedge fund gains or convert them into long-term gains, but these techniques bring their own complex challenges.
13 Managing hedge fund tax issues is a very complex subject, but suffice it to say here that no hedge fund belongs in your portfolio unless its after-tax results are satisfactory relative to the risks being taken. This is true of all investments, of course, but few are as tax-disadvantaged as hedge funds.
Lack of transparency. For investors who are used to tracking their portfolio results on a frequent basis, the lack of transparency that characterizes hedge fund portfolios is likely to provide a whole new experience. What is transparency all about?
14 Transparency refers to the ability of an investor in a hedge fund to understand what the manager plans to do, how he plans to do it, and whether he is actually doing it. Without transparency, investors can't understand the nature of the risks they are taking, and hence cannot, for example, hedge those risks by investing with managers using other strategies.
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Conflicted prime brokers. In a typical separate account money management arrangement, cash and securities are held by a bank acting as custodian. The manager has only a limited power of attorney to direct the investments in the account, but cannot remove funds from the account. The investor is the bank's customer, not the manager. If anything even remotely fishy is going on in the account the bank will notify the investor immediately. Hedge fund accounts, however, are not custodied in the usual sense. Instead, the funds reside with a “prime broker,” typically an investment bank or brokerage firm that serves as global custodian, broker, lender (via margin loans), vendor of derivative transactions, and even fund-raiser for the hedge fund. The customer is the hedge fund, not the investor. Prime brokers play so many roles, have so many conflicts of interest, and earn such large profits for their firms that they cannot be counted on to blow the whistle on shenanigans committed by hedge fund managers with whom they work.
Hedge fund advantages are also disadvantages. In the upside-down world of hedge funds, virtually every advantage claimed by the industry also represents a potential disadvantage for investors. For example, Jonathan Lach lists the following burdens hedge fund managers are able to avoid (relative to other money managers): “excessive capital under management, benchmark objectives, diversification requirements, daily liquidity, and significant organizational time demands.”
16 Lach is right, and these are in fact important advantages of hedge funds. But many investors will view all but the first and last
17 of these not so much as burdens to be avoided but as important risk controls. Or consider the “advantage” that many hedge fund managers have much of their own money invested in their funds. This is certainly an advantage in the sense that such a manager is likely to pay close attention to the business. But that is a different issue from the question of whether the manager's interests are aligned with the investor's—they typically aren't. If a manager has much of his net worth invested in his fund while a typical investor has only a modest portion of his net worth invested in the fund, the interests of manager and investor are structurally misaligned from the beginning. Moreover, manager and investor may have different time horizons and may have very different feelings about leverage, downside risk, long and short exposures, and so on.
High fees. Hedge fund managers charge annual fees of 1 percent to 2 percent, plus (usually) 20 percent of any profits. Some managers are worth every penny of this, but they are rare, indeed. In other words, there is nothing inherent in the hedge fund format
18 to justify such fees—only talent justifies them. Investors who don't aggressively seek out talent are likely to be disappointed in their hedge fund returns in part because too much of the return is going to the manager.
Mischievous fee structures. Hedge funds often have both a hurdle rate and a high-water mark. The hurdle rate means that the manager cannot get any part of his 20 percent share of the profits until the fund has exceeded some preset annual rate of return—8 percent, for example. The high-water mark simply ensures that, once a loss has been incurred in a fund, the manager cannot receive his 20 percent share of the profits until the loss has been recovered. Both elements of the fee structure are perfectly fair, but they can easily combine to produce odd incentives. Consider a fund with a 1 percent annual fee, an 8 percent hurdle rate and a high-water mark provision. The fund starts with $100 million in year one, rises to $200 million in year two (a hell of a year, to be sure), declines to $150 million in year three, and rises to $175 million in year four. In year four, the fund is not yet back to its high-water mark of $200 million. In addition, the manager has failed, over years two and three, to earn the 8 percent hurdle rate. Moreover, as the hurdle rate piles up and the high-water mark looks more and more unattainable, the manager is faced with receiving nothing but his 1 percent annual fee for many years. He didn't go into the hedge fund business to earn a 1 percent fee, so what does he do? As Roland Lochoff puts it, “It is not uncommon for a fund to fall so far underwater that the chance of ever reaching the high water mark is improbable. It simply pays the hedge fund manager to go out of business and start afresh with a new name.”
19 In other words, heads he wins, tails we lose.
High tracking error. Investors who have traditionally focused on tracking error to monitor their managers will be sorely disappointed with hedge funds. It is virtually impossible to create a benchmark that will be useful for monitoring a hedge fund portfolio. As a result, whatever benchmark is used, tracking error will be impossibly high—so high as to be largely useless as a manager-monitoring tool.
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Correlations increase just when you need them not to. Over long periods of time, hedge funds have demonstrated low correlations to the equity and fixed-income markets. Unfortunately, during liquidity crises (August 1998, the summer of 2002, 2007–2008, for example), the correlations between hedge funds and marketable securities increase dramatically—just when you most need the diversification. In other words, hedge funds provide diversification over the long run but not over the short run.
Selling beta as alpha. Investors can buy beta cheaply—via index funds, exchange-traded funds, futures, and so on. Alpha is expensive, and properly so, because it is so rare. Hedge funds charge very high fees because they claim to be delivering alpha. Some, surely, are doing so, but most are simply expensive beta shops. Bridgewater Associates once measured the performance of managers in seven popular hedge fund strategies against the performance that would have been obtained by naively replicating the systematic risks taken by the managers. They found that the naive strategies typically outperformed the average hedge fund manager.
22 To take a simple example, instead of investing with merger arbitrage hedge funds, an investor could simply buy the top 10 acquirees during any given year and sell the top 10 acquirers short. That investor will likely have achieved a return that is higher than the aggregate returns of merger arb hedge funds.
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The difficulty of ongoing monitoring. It is difficult to perform enough diligence on a hedge fund to justify investing in it. But, unfortunately, that is far less than half the battle. Investors in hedge funds find themselves in hot water not so much because of the lack of up-front diligence—though there is a lot of that going around—but because of the almost complete lack of ongoing diligence. It is hardly an exaggeration to say that most investors' ongoing diligence is limited to checking their returns. But an ongoing understanding of exactly what our hedge fund managers are doing, why they are doing it, and how well they are doing it is critical to avoiding disasters. It is exceptionally rare for a hedge fund manager simply to blow up with no warning whatever. More typically, there were alarming red flags flying for months or years before the blowup, but most investors weren't paying attention. Some of those red flags should have been identified in up-front diligence—a checkered regulatory or personal history, for example. Others show up only months or years later. An example would be suspiciously good or consistent performance versus other similar hedge fund managers (think Bernard Madoff.) Another would be an increase in leverage or other kinds of risky behavior. Ongoing diligence conducted at a level of detail that matters virtually requires (a) spot-checking position-level detail for each manager (though not necessarily in real time), and (b) a staff with the trading sophistication to understand what the trades mean. The group of investors who can't perform this sort of diligence includes virtually all private families and family offices, virtually all investment consulting firms, and, alas, most hedge funds of funds.
In the face of all these challenges, it is inevitable that, as has always been the case with private-equity funds, performance dispersion among hedge funds will widen until, unless we are invested with top quartile funds, we should, like Yogi Berra, have stood in bed.
