Fair dues

The best hedge funds have earned huge amounts of money for their investors. There is no better account of these endeavours than 'More Money Than God', by Sebastian Mallaby, formerly of The Economist magazine. Simple charts at the end of his book set out astounding investment records. However, its 'Lives of the Saints' tone could deceive. The hedge funds into which your pension manager and my life assurer have invested over recent years are unlikely to boast astounding investment records. Indeed, many of Mallaby's master investors closed to new money or even closed altogether well before hedge funds entered the investment mainstream.

A rather different picture of the sector emerges from 'The Hedge Fund Mirage' by Simon Lack, (see last week's column). Mr Lack assesses the hedge fund sector as a whole, through the HFRX Index which tracks the performance of 40 large funds. He estimates that hedge funds made total profits of about $760bn between 1998 and 2010 (this is the cumulative total of row (b) in the table). This number sounds impressive but of course is in fact meaningless by itself. Any old fool could have earned $760bn during this period if he had had enough capital.

For example, in 2006, when hedge funds earned about $208bn, they had $1,500bn of funds under management. Well, you could have invested that in riskless treasury bills for a return of 5 per cent, or $75bn. It's the difference – of $133bn in 2006 – that is the real measure of hedge fund performance. But that's not the figure that matters to investors, because it does not take account of hedge fund fees. According to Mr Lack, in 2006 these were a $75bn, therefore leaving $58bn of 'real profits' for hedge fund investors.

Now you could add the $58bn of 'real profits' to the 'risk-free' profits of $75bn and have an interesting debate (for which, see the book). But, for another angle on the same issue, you could simply compare all the 'real profits' booked to hedge fund investors with all the fees charged by hedge fund managers. The resulting unhappy sight is depicted in the bottom two rows of the table. Apparently, up to the end of 2010 hedge funds had earned $441bn for themselves leaving $9bn of real profits for their investors. The fact that this includes a stunning recovery from the disaster of 2008 doesn't quite take the sting out of it.

In particular, imagine that you had been late into hedge funds, arriving in say January 2005. By my guesstimate, some $600bn of new money arrived in hedge funds between 2005 and 2007. Assuming it stayed for the recovery of 2009 and 2010, it has so far paid fees of $85bn in return for real losses of $62bn.

Hedge fund defenders advance three serious arguments against Mr Lack's findings. First, that they are simply wrong. But alternative figures cited by the Alternative Investment Management Association (AIMA), which I have studied, are simply a couple of modest marketing slides from a hedge fund advisor. Second, that these results reflect investors doing what they do worst – rushing in too late. But as both Messrs Lack and Mallaby point out, model hedge funds have generally closed to new money if they got too large. Third: "The main problem with Lack's whole thesis is that no serious investor would tolerate for long a situation in which nearly all the returns were going to the manager and not them." That's verbatim from the AIMA.

Gosh, I wish I shared their confidence.

Who will gainsay this disturbing analysis?

$ billions1998199920002001200220032004200520062007200820092010
aTotal invested in hedge funds1311662132794146661,0271,2951,5371,9251,7971,5061,624
bTotal hedge fund profits before fees24584236331245470208141-381232117
cReturn before fees18%35%20%13%8%19%5%5%14%7%-21%15%7%
dWhat row (a) would have earned had it been invested in risk-free investments such as short-term government bonds78131177134175923122
eThe difference contributed by hedge funds, before their fees (b-d)1750292526117412913349-412230115
fHedge fund fees including fund-of-fund fees7151313153832427570463738
gFees as % of money invested5%9%6%5%4%6%3%3%5%4%3%2%2%
hThe 'real profit' earned by investors (row b minus rows d and f)1035161211799-1358-21-45819377
iCumulative fees earned by hedge funds722354863101133175250320366403441
jCumulative real profits earned by investors1045617384163172159217196-262-689

This is an expanded version of a table in The Hedge Fund Mirage. Row (a) is from Barclayhedge. Row (b) is based on the HFRX Index.

Row (f) – hedge fund fees – is directly from the book. It is necessarily based on several assumptions and in my view errs on the low side.

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