April 23, 2012 9:08 pm

Hedge fund industry fights back on criticism

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The hedge fund industry has never been bigger.

According to figures released last week, hedge funds now manage more than $2.13tn in assets on behalf of their clients. Gone too are the merely superwealthy: the majority of hedge fund investors are now pension funds, insurance companies or other sophisticated institutions.

But this does not mean that hedge funds are better. Last year was the second-worst year for hedge funds on record. The average fund manager lost 5.25 per cent in 2011, a drawdown only worsened in 2008. The post- crisis world has been unkind.

Indeed, for many, such numbers underscore an unpleasant truth: hedge funds are expensive follies

The criticism is not new, but in recent months, fuelled by the performance dip and a number of high-profile losers – John Paulson’s damaging 51 per cent loss, the industry’s worst ever in absolute terms, for example – it has been growing in volume.

Simon Lack, a former JPMorgan banker, has become one of the hedge fund industry’s most vocal critics thanks to his book, The Hedge Fund Mirage, which has enjoyed popularity beyond the rarefied hedge fund enclaves of Mayfair and Connecticut. Last year was the ninth consecutive year that a simple 60:40 stock and bonds portfolio outperformed the average hedge fund, according to Mr Lack.

Even the very notion of hedge funds as “alternatives” in any investor’s portfolio is beginning to come into question. Since 2008, the average hedge fund’s performance has very closely mirrored that of equity markets, apparently giving lie to the promise of de-correlated returns.

Faced with such challenges, the industry is keen to fight back.

The Alternative Investment Management Association is today set to release data, drawn up in conjunction with KPMG by academics at Imperial College, that it hopes will draw a line under the debate.

Hedge funds have, on average, returned 12.61 per cent annually, the research will show: 3.54 percentage points of which is skimmed off by managers as fees, leaving investors to pocket an average 9.07 per cent annual return.

The numbers are hardly of the sensational, shoot-the-moon, type that the hedge fund industry is perhaps best known for, but they are consistent, and they are better than most other asset classes, Aima says.

“This analysis covers 17 years and demonstrates that over that period hedge funds significantly outperformed traditional asset classes,” says chief executive Andrew Baker. “Of course, during that timeframe there will have been individual years when hedge funds were outperformed, but this research looks at the bigger picture.”

A 60:40 stock and bond portfolio may well have done better than hedge funds in recent years, but an equally split hedge fund, stock and bond portfolio would have done the best, the research notes.

According to Robert Kosowski, director at Imperial College’s Centre for Hedge Fund Research, the quality of the returns hedge funds deliver also stands out.

Data analysed by Mr Kosowski show an annual “alpha” – an industry buzz­word that refers to the returns delivered by a manager’s skill rather than extraneous forces such as leverage or market direction – of slightly more than 4 percentage points.

Only 1.32 percentage points of hedge fund returns above a passive benchmark are, meanwhile, due to beta, or market risk factors, according to the research.

The question, as always, however, remains how such returns can be accessed. The average hedge fund does not exist in practice, and there are plenty of managers whose skills may not prove all that they seem.

“There are high-profile blow-ups or losers in just about every asset class you can invest in,” Robert Mirsky, head of hedge funds at KPMG, nevertheless points out. “Hedge funds are no better or no worse, from that point of view.”

More critically, perhaps, the Aima research comes as part of a broader drive at Imperial College to map, for the first time, an accurate “index” of hedge funds.

Traditional indices – of which there are several – are consistently criticised for overstating hedge fund returns.

Funds that implode or suffer negative performance may simply stop reporting figures to the databases, for example, flattering the picture of the industry as a whole, a phenomenon known as survivorship bias.

“Survivorship bias gets a lot of attention,” says Mr Kosowski.

“Some funds drop out because they have bad performance, but some funds also drop out because they have good performance,” he says. “The two actually cancel each other out.”

The hedge fund industry’s fiercest critics may not be silenced by such findings. But with most hedge funds already having made significant gains so far this year – and enthusiasm for hedge funds from big institutional investors remains undimmed – the industry may not actually need them to be.

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