Jay D. Franklin

Hedge Funds on Edge

A recent article in the Economist, “Dazed and Confused”, details what a difficult year 2011 has been for the $1.9 trillion hedge fund industry. The average hedge fund has fallen by around 9% this year compared to 3.4% for the S&P 500. In typical Brit fashion, the author reports an “unaccustomed timidity” prompting many hedge funds to reduce their leverage and decrease the volume of their trading activities. For some managers, doing nothing is untenable because of the difficulty in justifying the traditional two-and-twenty percent fee charged by hedge funds. As pointed out by Yale’s David Swensen, this fee structure creates a perverse incentive for managers to engage in high-risk transactions:

On top of the enormous difficulties of identifying a group of genuinely skilled investment managers and overcoming the obstacles of extremely rich fee arrangements, investors confront a fundamental misalignment of interests created by the option-like payoff embedded in most hedge fund fee arrangements. Investors in hedge funds find generating risk-adjusted excess returns nearly an impossible task. (Unconventional Success: A Fundamental Approach to Personal Investment, 2005).

One group of investors that chose not to heed Swensen’s admonition are the hapless souls who recently poured their dollars into John Paulson’s Advantage and Advantage Plus funds. Recall that Paulson was in the spotlight as one of the few managers who actually made money (about $5 billion) during the real estate collapse of 2007-2008. His exploits (such as working with Goldman Sachs to assemble collections of toxic assets that were sure to fail) were the subject of The Greatest Trade Ever by John Zuckerman. Seeing that his two funds have posted declines of 29% and 44% this year through October, investors who dove in because they expected a continuation of Paulson’s hot hand must feel like the greatest mopes ever. Paulson recently sent his investors a letter acknowledging that the fund’s performance is “the worst in the firm’s 17-year history” and said “we are disappointed and apologize.”  Mr. Paulson has even agreed to personally compensate one of his investors, New York’s 92^nd Street Young Men's and Young Women's Hebrew Association (which runs an extremely competitive preschool that caters to the elite of Wall Street), to the tune of $4 million. His other investors will not be so fortunate.

Index Funds Advisors, Inc. (IFA) continues to advise investors to steer clear of hedge funds for a multitude of reasons.¹ Not only can we say that little has changed for the better since 2004 when Forbes published The Sleaziest Show on Earth, but we have witnessed the financial decimation of certain hedge fund investors such as Fairfield Greenwich investors who became victims of Bernie Madoff’s Ponzi scheme. The Fairfield Greenwich website was replete with impressive-sounding language about their “due diligence” in manager selection when in fact they were nothing more than a feeder fund to Madoff. Hedge fund investors are at a true informational disadvantage due to the lack of transparency and lack of regulatory and reporting requirements. Investors are still best served by passively managed and highly regulated vehicles such as index mutual funds and exchange-traded funds.

¹ http://www.ifa.com/section/hedgefunds.asp