Mainstream Financial Press is Finally Catching on to Hedge Funds

Finally, the mainstream financial press is finally catching on to hedge funds; they're a rip-off. This from Forbes :

"At first glance, hedge funds appear to load management contracts with incentives to encourage good performance and to keep managers' interests in line with investors'. But in practice there is no way to encourage excellence without making scamming profitable as well...

"According to Foster and Young, investing in a hedge fund is like buying a 'lemon' - a car with hidden flaws. 'This is a potential "lemons" market in which lemons can be manufactured at will, and the lemons look good for a long time before their true nature is revealed.'

"While numbers are imprecise because reporting is light, there are more than 10,000 hedge funds today controlling about $1.9 trillion in assets, compared with more than 8,000 mutual funds with $11.7 trillion in assets.

"The typical actively managed stock-owning mutual fund charges annual fees of about 1.3% of the investor's holdings, while many passively managed index-style mutual funds charge 0.2% or less. Compared with this, hedge fund fees are very high, at 1% to 2% of assets and 20% of profits.

"If the market returned 8%, a mutual fund matching it would return 6.7% to 7.8% after fees were paid. A hedge fund with the same results would return 4.4% to 5.4% after fees.

"To offset these charges, hedge funds need dramatic results, but research indicates they have not been able to deliver over the long term. A 2007 study of 300 hedge funds by two University of Texas finance professors, John M. Griffin and Jin Xu, found that, from 1980 through 2004, hedge funds outperformed mutual funds by 1.4 percentage points a year. But that was before fees were taken into account. Moreover, the average was driven up by the tech-stock bubble of 1999 and 2000; otherwise, hedge funds did no better than mutual funds.

"In [a] hypothetical example, a fund manager named Oz sets up a $100 million hedge fund with the goal of earning 10 percentage points a year above the 4% annual yield of one-year government bonds. The fund will run for five years and charge a management fee of 2% of assets and an incentive fee of 20% of any profits that exceed the bond yield.

"Oz creates and sells a series of 'covered calls' and sells them for $11 million. Each call is a stock option that will pay the investor who bought it $1 million if the stock market rises by a given percentage. Using historical information, Oz figures there is only a 10% probability the market will rise that much. If it does, the hedge fund will be virtually wiped out by being forced to pay $111 million to the call owners. If it does not, the fund will pay nothing - and the $11 million received from the call buyers will be profit.

"Oz now has $100 million received from his investors, plus $11 million from the options sales. He invests the $111 million in risk-free U.S. Treasury bills earning 4%. After a year, the fund thus grows to $115.5 million. To his investors, this is a 15.5% return on their original $100 million.

"Oz earns his 2% management fee on the $115.5 million, plus 20% of the return exceeding what came from the 4% Treasury yield - or 20% of $11.5 million.

"There's a 59% chance this process can continue for five years without a market downturn annihilating the fund, allowing Oz to collect $19 million in fees, as compounding makes the fund grow larger and larger. If the market does crash, Oz can close the fund, leaving the investors with devastating losses but keeping the fees he's been paid to that point.

"This simplified 'piggy-back strategy' involves no borrowing, or leverage. A real-world manager could inflate his incentive fee by borrowing money to increase the size of his bets, though that would deepen the investors' losses if things went wrong.

"The bottom line is that Oz's investors, who don't know what he is doing, may well believe his market-beating results come from brilliant stock picking or other wizardry. In fact, anyone could set up this simple strategy. Moreover, the investors are in the dark about the risks they are taking. They might well assume that if they make in excess of 15% one year, they might lose 15% in another. In fact, there's a 10% chance they will lose more than 95% of the money they put in."

Bill Bonner
The Daily Reckoning Australia

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