Melissa Johnson
Two and Twenty: So how’s that working for you? The Underperformance of Hedge Funds
Melissa Johnson
Thursday, January 05, 2012
The returns of hedge funds have trailed behind those of the S&P since 2003: 18% vs. 29% total returns, according to Simon Lack of SL Advisors in a Wall Street Journal “MarketBeat” article. The 2% management fee and 20% performance fee (20% of the fund’s profits) add to the wide spread between returns. The difference in returns could possibly be even wider, because hedge funds get to decide if they want to be included in databases that are tracked and analyzed. In other words, there is a selection bias.
The article presents another comparison: hedge funds vs. a corporate bond index, as measured by the Dow Jones Corporate Bond Index. The index has grown 77% since 2003, adding to a list of examples demonstrating the underperformance of hedge funds when compared to market benchmarks.
As Jay Franklin cited in a previous IFA article, “every major category of hedge funds (eleven categories) on average failed to provide a higher risk-adjusted return than the S&P 500 from 1995 to 2003. Only one category (emerging markets) provided a higher unadjusted return than the S&P 500.”
Lack credits the underperformance of hedge funds to the large influx of assets into hedge funds over the last ten years, followed by a dissipation of “alpha” or outperformance “as more managers chase after a limited pool of market inefficiencies.” Data from Hedge Fund Research shows that the amount of capital raised from 1998 – 2002 more than doubled to $820 billion.
Lack advises investors who have an investment time horizon of five or more years to invest in U.S. stocks rather than hedge funds and addresses this issue in his new book, The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good To Be True.
New standards and fee models are being considered by certain hedge funds, which could enable investors to keep more of their money.
For further information on hedge funds, read Jay Franklin’s articles:
“IFA’s Concerns with Hedge Funds” @ www.ifa.com/section/hedgefunds.asp
“Hedge Funds on Edge” @ http://www.ifa.com/articles/Hedge_Funds_on_Edge.aspx
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