Hedge Funds Won't Make You Rich

Why would people expect hedge funds to deliver superior returns in the first place? 
Does this bring to mind a hedge fund?                                            Photographer: Chris Ratcliffe/Bloomberg

The recent release of Institutional Investor Alpha’s hedge-fund survey has everyone asking how the fund managers continue to make so much money. Academics and journalists alike point out that hedge funds, as a class, haven’t delivered above-market after-fee returns for quite some time. Hedge funds, of course, get paid whether the market goes up or down, so the real question is why hedge funds continue to receive large inflows of capital from pension funds and other investors. The New Yorker magazine’s John Cassidy has a good roundupof the most prominent theories. He includes some good links to research on the question of whether hedge funds deliver superior risk-adjusted returns, or offer significant diversification potential.

But the real question is: Why would people expect hedge funds to deliver superior returns in the first place?

People often seem to treat the term “hedge fund” as if it’s a shorthand for “money manager of unusual skill.” At the Skybridge Alternatives Conference (SALT) last year, host Anthony Scaramucci told attendees that “Mutual funds are the propeller planes…while hedge funds are the fighter jets.” And of course we’ve all heard of those famous world-beating billionaire hedge-fund managers like John Paulson, Ken Griffin or Cliff Asness.

But is there any fundamental characteristic common to all or most hedge funds that makes them “fighter jets”? “Hedge fund,” after all, is just a legal category. There are regulations governing what kind of assets a fund is allowed to trade, and what kinds of clients the fund can service. Hedge funds are only allowed to sell to certain types of investors -- rich people, large institutions and those who qualify as so-called sophisticated investors. In exchange for this limitation on who can invest in them, they are exempt from most restrictions on what kinds of assets they can trade and how much leverage they can take on.

Theoretically, this exemption should mean that hedge funds offer the potential for diversification. Since they can invest in things other funds can’t, buying into hedge funds can theoretically give an investor access to a wider universe of assets.

But beyond that, there is little reason to believe that hedge funds as a group offer anything special. After all, any Tom, Dick or Harry can start a hedge fund. That’s right -- all you need is a business license. You can start a hedge fund without ever having managed a dime of money in your life. That’s called “free entry.” In economics, free entry means that average profits in an industry (net of opportunity cost) should be competed away to zero. Why should hedge funds be any different?

In other words, if a pension-fund manager or rich investor hurls his money at a fund just because it's called a “hedge fund,” he isn't making a sophisticated, market-beating choice; he is paying through the nose to take a lot of risk and get a bit of diversification. Thus, it’s no surprise that during the past couple of decades, even as money has continued to flow into hedge funds, their return hasn't impressed. Free entry has competed away the ability of the hedge-fund class to beat the market.

So how did hedge funds get such a good reputation? Well, it’s possible that their eye-catching early performance was a kind of loss leader. In the beginning, investors probably shied away from this scary new asset class, so higher after-fee returns were necessary to convince them that hedge funds were for real. After the word got out about the high returns and hedge funds became known as “fighter jets,” hedge funds were free to charge higher fees and a huge flood of scrubs entered the profession. The net result was that after-fee returns to the hedge fund class as a whole collapsed.

Now, this doesn’t mean there aren’t hedge-fund managers who can beat the market. As in the venture-capital industry, there seem to be a few superstars who really can deliver superb performance, year in and year out. You already know many of their names. The catch is, these superstars are unlikely to need your money. By the time we discover them, they already have a lot of capital, and taking on more would make it hard for them to keep generating market-beating returns. In other words, the only way to find a hedge-fund who can reliably beat the market for you is to pick one who’s not yet a star, but is destined to become one.

So here’s the real question: Do you, as a pension-fund manager, or rich individual investor, think that you have an above-average ability to pick out the non-superstar hedge funds that will outperform in the future? And if so, why? Also, is your superior fund-picking ability worth the average hedge-fund fee?

If you decide the answer is “no,” then you should consider investing in an index such as the HFRX Global Hedge Fund Index, which replicates hedge-fund returns net of fees -- so it helps with portfolio diversification but not fee reduction.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

    To contact the author on this story:
    Noah Smith at nsmith150@bloomberg.net

    To contact the editor on this story:
    James Greiff at jgreiff@bloomberg.net

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