The article repeats the oft cited mantra of those that have drunk the hedge fund kool aid:
A number of recent studies show that hedge fund investors are satisfied with the performance of their investments, even if that performance appears on paper to be less than stellar. Widespread demand for risk-adjusted returns of 8 to 10 percent ensures that the money spigot will stay turned on. (Risk adjusted means that the portfolio is hedged. If the market slumps, the fund’s returns should not.)
I have yet to see the evidence that these funds, which often engage in leveraged investments could possibly generate long term returns equal to the long term expected return of stocks with lower risk. While the laws of economics are not the laws of physics the idea that an entire asset class has found the goose that lays the golden egg: higher returns with no more risk is literally incredible. And what does is this assertion based on: nothing more than a belief that an entire asset class is managed by absolute geniuses !!
As the article itself states:
There are more than 9,000 funds that vary greatly in the kinds of investments they make, returns they seek and strategies they employ.
Are we to believe that among these 9,000 funds or even a significant minority of them we find managers who have suspended the Nobel prize winning theories of finance (risk and return ) are linked at the hip.
Then again the author doesn't quite know her finance she writes:
Widespread demand for risk-adjusted returns of 8 to 10 percent ensures that the money spigot will stay turned on. (Risk adjusted means that the portfolio is hedged. If the market slumps, the fund’s returns should not.)
Well that is just wrong. As in the case of options a porfolio can be hedged and still lose money. Joe investor buys a stock at 100 and buys an 80 put. The stock falls to 60. He is hedged because he lost $20 (+ the option premium) versus the unhedged investor who lost $40. But he still lost money.
Despite the availability of expertise to disabuse them of their illusion across the quad among the Finance faculty college endowments are flocking to these hedge funds:
For example, the top performers of the 2007 Commonfund Benchmarks Study of Educational Endowments, a survey of college, university and other educational endowments and foundations in the United States, were almost 50 percent invested in “alternatives” — hedge funds, private equity, real estate, distressed debt, energy and natural resources and venture capital.
Hedge funds constituted the largest portion — 44 to 70 percent — of the alternatives category
Now that is a mouth dropping statistic : 25 -35% of the endowment dollars are in hedge funds.
And Surprise look what the results are:
Even though hedge funds represented the bulk of investment dollars, their returns were lackluster. In 2006, the Standard & Poor’s 500-stock index had a total return, when dividends were reinvested, of 15.8 percent. Overall returns for alternatives averaged 14.6 percent. Energy and natural resources produced a stunning return of 40 percent; distressed debt, 26 percent; and private equity, 19 percent. Hedge funds turned out only 10.6 percent. But investors did not seem to be bothered.
You can throw out the energy and natural resources return number as having anything to do with expected long term returns. Anything else would reflect a severe case of what behavioral economists call "recency" (what happened last year will happen in the future).
But the kool aid drinking goes on:
“It was nice to see hedge funds were doing what they are supposed to do,” said John S. Griswold Jr. executive director of the Commonfund Institute, a research organization dedicated to educating the nonprofit community about investing. “They should lag a rapidly rising stock market,” he explained, “because hedging has a cost.”
Mr Grisworld should get some education himself at a business school (basic finance textbook):
The only way to reduce risk and be truly hedged in an investment portfolio is to buy puts (giving away some upside) or adding (not subtracting as they are doing) short term bonds to a portfolio. WHat they are doing is simply putting faith in a "genius" (and one that takes 20% of the returns for himself). Figure a long term return for stocks is 8% and for bonds 5%. A 70/30 stock bond portfolio return would be 7.1%. A hedge fund would have to turn in a return of 8.5% (after fees) to generate that return for the endowment. So the expectation is that the hedge fund will be able to consistently have the same risk as a 70/30 portfolio and generate higher returns after fees at the same time. Yes, it must be the goose that lays the golden egg.
and here is one of the illogical conclusion that one of my favorite authors Naseem Taleeb likes to point out.
Heavy investments in alternatives and hedge funds in particular have paid off for endowments. More than 79 percent of the growth in endowments with assets of $500 million to $1 billion resulted from investment returns (as opposed to gifts, for example). Institutions with more than $1 billion derived more than 75 percent of their returns from their investments, according to the Commonfund survey.
1. Since the article already stated the S+P 500 (assumedly under the period under examination) outperformed the hedge funds, a more accurate statement would be" investing in alternatives hurt endowments as opposed to simply investing in an index fund,
2. Now this one is really a beaut
Heavy investments in alternatives and hedge funds in particular have paid off for endowments. More than 79 percent of the growth in endowments with assets of $500 million to $1 billion resulted from investment returns (as opposed to gifts, for example)
This says absolutely nothing about the investment returns and quite a bit about the fundraising prowess of the universities. If an endowment grew it's gifts by 2.5% and stuck all its investments in a money market account at 5%, its endowment would grow more from investments than gifts. And if a college with a $100 million endowment got a $20 million gift, it would have grown in that year more from gifts than investments. Unless of course their hedge fund genius generated a 20% return.
Attention endowments : want to generate better risk adjusted returns for your endowment : ramp up the fundraising.
Of course no matter how bad hedge funds are for endowments the case is much more so for individuals. A few reasons:
1. The best performing (given the caveats) hedge funds require minimums of $10 million or more. You're not going to find them in that $100,000 "fund of funds" your broker is offering.
2. Endowments are able to often generate lower fees than the standard 2 and 20 (2% annual fee + 20% of the profits). Using the 2 and 20 formula the fund manager would have to generate a return of 12.5% to give you an after tax return of 8% (the long term expected return for stocks). If you think he can do that at less risk, you visited that endowment manager and were served some kool aid.
3. Endowments pay not tax on their investments. You on the other hand will get whacked in taxes from your hedge fund. Hedge funds trade actively so they are either on a mark to market basis (they pay tax on realized and unrealized gains) or they likely get their profits taxed almost entirely at short term (regular income tax) rates. Those taxes come out of returns whether or not you take money out of the fund. A strategy with index instruments will generate minimal taxes unless you take money out of the fund. And if you do take the money out and held the fund over one year you will pay lower long term capital gains rates.
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