Posted in Friday’s Financial Question. This week’s Financial Question is about alternative investments.
QUESTION: Duncan, hedge funds are the talk of the cocktail party, what’s your view. Should I be investing?
ANSWER: In short, no!
Financial products are often bought as a means for people to express beliefs, acquire status or even appear sophisticated. In the same vein, hedge funds can be likened to a classic British sports car, offering more cachet than a traditional (investment) vehicle, but lacking the reliable performance that helps get an investor safely from point A to point B on a risky and often congested financial superhighway.
This is why:
- Hedge funds are not an asset class but a compensation structure. Provided hedge funds restrict access to “sophisticated” investors only, they can avoid making their performance public or having their numbers audited. But among the most noteworthy characteristics unique to hedge funds are their use of leverage and their often complex fee structures. The most common compensation structure in the hedge fund business is the so-called “two and twenty”, where the manager charges a 2 per cent annual fee and receives 20 per cent of the profits. This fee structure, which has produced astronomical manager pay, is one of the stark dividing lines between hedge funds and traditional collective investment funds.
- The available data on hedge funds are far from perfect. Hedge funds are currently under no obligation to disclose their results. Consequently, hedge fund databases are of very low quality and are filled with backfill bias (managers only report after they have good performance) and survivorship bias (data vendors only supply data on funds that are still in operation). These two factors can compromise any analysis of hedge fund returns, with some studies concluding that survivorship bias alone overestimates returns by 2 to 4 per cent and underestimates risk by 10 to 20 per cent.
- Analysing the performance of hedge funds is difficult at best. A common claim from hedge fund managers is that their strategy offers substantial diversification benefits by virtue of being uncorrelated with anything. This claim generates two positive outcomes for the managers. First, the diversification story is a central part of the sales pitch, and second, there is no way to effectively evaluate results if performance is indeed uncorrelated with anything.
- Hedge fund manager selection is no easy task.Many investors select managers based on their historical record, although it is not necessarily the case that managers who have done well in the past will do well in the future. The lack of performance persistence exhibited by professional money managers has been well documented. Although the data for hedge fund managers are not as robust as for collective investment fund managers, some early results indicate their performance may also be fleeting. And since most data vendors only started collecting data on hedge funds in 1994, the available data are very limited. As Professor Eugene Fama of the University of Chicago pointed out, it takes roughly 40 years of stock market data before the equity risk premium is statistically significant. Needless to say, it will be a long time before we can draw any meaningful conclusions about hedge fund returns.