January 12, 2012 / 8:51 PM / 6 years ago

Hedge funds (What Are They Good For?): Saft

6 Min Read

(Reuters) - Not only was it a bad year for the hedge fund industry, but 2011 may be the year the model was exposed as fundamentally broken.

Last year had all of the hallmarks of the kind of year in which hedge funds are supposed to earn their keep. Volatility was extremely high and market performance was very mixed.

The year was rough sledding for some formerly high-flying managers such as John Paulson and Whitney Tilson. Even worse, preliminary data show that not only did hedge funds globally have a losing year, but that the typical fund in every single major geographic region suffered losses.

Most disturbing of all is recent research that indicates that the aggregate data used to justify the performance of the industry is being systematically inflated.

I used to think that hedge funds, like canary yellow Rolls Royces or haute couture, were simply an expensive joke the rich play on themselves, but now that the industry is increasingly marketing itself to retail it is time to truly hold it accountable.

There are grave reasons to believe that the average hedge fund client is not well served by the products, which typically charge an annual fee of about 2 percent as well as 20 percent of all profits over a benchmark. Investors in fund-of-hedge funds or products aimed at retail investors usually pay even more.

Data from HedgeFund Intelligence tell a very sad story about 2011 returns. Its indexes of U.S., European, Asian, fund-of-fund and UCITS (a type of fund offered in Europe) funds all recorded losses for the year, according to preliminary data. here

The global composite index was down 1.91 percent and a whopping 60 percent of funds ended the year in the red. When you consider that the S&P 500 index was up two percent, including dividends, and the bond market returned about 8 percent, this is a very poor showing.

End of Alphaville

Hedge funds, as an industry, market themselves in two main ways. One is the "absolute return" idea, that the funds, freed from having to track a given index and able to use leverage, can make good absolute returns and make money in any weather.

Apparently not, at least judged by 2011's showing.

The other is the idea of "alpha," which is essentially the concept of excess returns a manager can generate on a risk-adjusted basis. This magic powder exists, supposedly, and is largely down to the superior skills of the hedge fund managers themselves, who quite naturally work in this industry because it pays them so much better.

While those 2011 performance figures look pretty weak, the truth may be far, far worse. A new study by academics Adam L. Aiken, Christopher P. Clifford and Jesse Ellis indicates that the hedge fund industry may be systematically over-reporting its returns to investors.

The thing to understand here is that participating in hedge fund return indices, which are commonly cited as vindicating the industry, is entirely voluntary. That means we should view hedge fund return data about as warily as we would the stories high school kids tell each other about their love lives - entertaining, perhaps, but not to be relied upon.

The study finds a "severe" self-selection bias in these indices, meaning that the established hedge fund benchmarks overestimate returns because many poor performing hedge funds don't choose to submit their statistics.

The industry is like a poker player who tells you about his big wins, but changes the subject to sports when he's on a losing streak.

Hedge funds commonly claim that they cash in on 3 percent to 5 percent annually of alpha, or excess returns on a risk-adjusted basis. Adjust for the self-selection bias found by the authors, however, and you get alpha of just 0.20 percent annually, hardly justification for shelling out a chunky two percent annual fee plus 20 percent of the profits.

"The managerial skill documented in previous studies is, in large part, overstated," the authors wrote. here

"Rather than fund managers having ability to consistently deliver superior risk-adjusted returns, it appears that much of the previously documented skill of hedge fund managers can be explained by the upwardly biased returns data employed by researchers."

This also tends to undermine the argument that hedge funds don't require tighter regulation. Their systemic threat may be larger than estimated, both because the tail-risk among poor performers is greater and also because, human nature being what it is, those poor performers who are not being counted may well include heavy users of leverage.

None of this is to say that great, strong performing hedge fund managers don't exist. The problem rather is that you are unlikely, statistically, to find one and even less likely to be able to get some money in with her if you do.

What is likely, indeed almost a sure thing, is that you will pay more and not get fair value in return.

(At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on)

Editing by Walden Siew

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