The Most Fascinating Investing Paradox

Investors keep pumping money into hedge funds, even though they would do better buying index funds.

One area of hedge-fund overperformance.

Photographer: Manjunath Kiran/AFP/Getty Images

Earlier this week, Greg Zuckerman of the Wall Street Journal pointed out one of the great mysteries of today's investment landscape: Despite underperforming by a substantial margin, hedge funds keep attracting more investors and assets under management. It is almost as if (to borrow the headline on Zuckerman’s article), "Hedge Funds Keep Winning Despite Losing."  He wrote:

Hedge funds aren’t just underperforming against the S&P 500 and other stock indexes. They’re also losing out to low-cost “balanced” mutual funds that hold a mix of stocks and more-conservative investments, just like many hedge funds, suggesting their poor performance can’t be blamed on a hedged approach.

Consider the data: According to HFR, a firm that created indexes to track hedge-fund performance, the average hedge fund gained a mere 3 percent in 2014 versus an 11 percent rise in the Standard & Poor's 500 Index. That's hardly worth paying a hedge fund outsized 2 percent management fees plus a 20 percent cut of the profits.

Simon Lack, in his book "Hedge Fund Mirage," describes why indexes such as those developed by HFR significantly overstate returns. That 3 percent gain last year, or about 7 percent annually since 2009, likely excludes funds that underperform. Funds don't have any obligation to report their performance -- it's strictly voluntary. What we see in these indexes is an absence of poor performers that, were they included, might give a more accurate picture of the industry's results. And that’s before we get to the issue of survivorship bias -- funds that have gone belly up and closed due to their dismal results are missing from the index as well.

Perhaps you believe that the S&P 500 is an inappropriate benchmark. Consider a simple 60/40 portfolio of stocks and bonds. According to research from the Vanguard Group, that simple portfolio beat the returns of not only the hedge-fund industry as a whole, but almost all of the individual funds except for the outlying performance stars. And this 60/40 portfolio did it while charging fees of just 0.24 percent. The balanced fund beat the main Bloomberg hedge-fund index in six of the last seven calendar years, according to data compiled by Bloomberg. No wonder there is so much angst in Greenwich, Connecticut, home to many hedge funds. See the following chart comparing the S&P 500 and the Bloomberg Global Aggregate Hedge Fund Index since January 2010:

SPX Index (S&P 500 Index)  Daily 2015-02-12 08-52-43
Source: Bloomberg

Now comes finance’s most fascinating paradox: Despite the underperformance and high fees, hedge funds now have $2.85 trillion in assets under management. That is a 78 percent gain from the $1.6 trillion in 2009. 

We have delved deeply into the issue of why hedge funds underperform, the dilemma that allocators face when choosing  hedge-fund managers, and why, despite all of this, "Investors Still Love Hedge Funds." 

The best answer I can come up with is that investors are irrational. Hardly a groundbreaking insight, I know, but it is the best explanation I’ve been able to reach. 

People who have thought about this question long and hard offer two other possible explanations. The first is the concept of inflated expected returns, while the second is the principal-agent problem.

I have yet to figure out a rational basis for the inflated expected return assumptions that endowments and public-pension funds use when making their alternative investments. The best, albeit most nefarious, reason that states use inflated expected returns is that it reduces the amount the state must contribute in any given year to their pension funds. That lowers the amount they need to tax their citizens to meet their legal obligations. When given a choice between embracing an obvious lie told to them by their state treasurers or investment committees, or raising taxes, most politicians are all too happy to embrace the lie.

That leads us to the principal-agent problem. The industry consists of fund managers (agent) who are empowered to act on behalf of another party, their investors (principal); but many of these agents don't have a true legal fiduciary obligation to act in the best interests of the principal. Ostensibly motivated to perform on behalf of their employers, but not legally under that obligation, it's not too difficult to figure out what happens next.

This is of a piece with the “amazing disconnect” that Simon Lack described to John Cassidy last year in an article in New Yorker magazine. Lack observed: “The entire hedge fund industry is designed to channel assets into hedge funds. Everyone - consultants, advisers, funds of funds, capital introduction groups of prime brokers - recommends investing in hedge funds. Nobody is providing the opposite view.”

Based on those capital flows, that amazing disconnect is alive, well and growing. 

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