Profits at a price in the world of hedge funds

Why follow the investment herd when the sharpest minds in finance can make money for you whether markets go up or down? But all, of course, for a price. This idea, give or take a few tweaks over the years, has been the consistent pitch by hedge fund managers to potential clients.

The term “hedge fund”, as the name suggests, owes its origins to an investment style intended to allow investors to be hedged against any large market falls. This meant, in theory, investors could be protected against a big sell-off while being able to take advantage of opportunities to make money.

Hedge funds were once the preserve of the super-wealthy — who sought out these supposedly secretive and alluring money managers, who were rumoured to be consistently generating world-beating returns — but the profile of a typical investor in hedge funds has changed considerably over the years.

The biggest investors in these so-called “alternative” assets are now pension funds, which have embraced hedge funds in the belief, sometimes disputed, that they are diversifying their investment returns away from their existing holdings of equities and bonds.

Yet what exactly is a hedge fund, and how does a private investor go about investing in one?

As time has gone on, the definition of a hedge fund manager, compared with a more conventional mutual fund or asset manager, has become more complicated.

First, not all hedge fund managers hedge, meaning they do not take out protection in some form against the wider market falling. There are also hedge fund managers that invest in hundreds or even thousands of securities at the same time, and others that choose to run only highly concentrated portfolios made up of only a handful of holdings.

Typically, hedge funds have been associated with shorter-term, opportunistic investment styles, and their ability to engage in so-called short selling, or betting on particular shares falling in value. Yet while many of the world’s leading hedge funds regularly trade in and out of stocks, and use short selling as one of their main investment techniques, other hedge funds hold their positions for several years — longer than the typical conventional money manager. Others do not short sell at all and instead intentionally take on large amounts of concentrated risk focused on their best ideas.

Likewise, many of the world’s best known hedge fund managers, such as George Soros, the man famed for “breaking the Bank of England”, made their names by making bets on the direction of the global economy and how this would affect interest rates and currencies.

Other renowned hedge fund investors have largely eschewed this so-called “global macro” style of investment, and have made consistent returns by focusing instead on the “micro”, or fundamental details, of shares in individual businesses.

In addition, many of the largest hedge funds rely less and less on humans, instead using computer-driven trading models, or algorithms, to spot patterns and relationships across markets which they can exploit to make money.

So, a new investor may ask, if they are all doing such different things, what, if anything, do these hedge funds have in common?

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The answer is the fees they charge investors for their services. Unlike most conventional asset managers, hedge funds of all stripes charge both a flat annual management fee and take a cut of profits they make on top of that.

The model — often referred to as “two and 20” because of a one-time industry standard of charging 2 per cent of assets under management a year and 20 per cent of profits — has made leading hedge fund managers fabulously rich, and has attracted criticism from investors.

Last year, the California Public Employees’ Retirement System (Calpers), the largest public sector pension fund in the US, said it was eliminating its entire $4bn of investments in hedge funds, citing concerns over their expense and complexity.

Much of this criticism has stemmed from several years of poor post-crisis performance from large swaths of the hedge fund industry.

A Financial Times analysis of industry data from HFR and Preqin found that at the start of 2008 public pension plans held about $380bn with hedge funds, and gave a further $70bn to the industry to invest over the following six and a half years. For this the pension funds received about $95bn in investment gains, based on the performance of the average hedge fund. The hedge funds themselves took about $68bn in fees for managing the money.

This equated to public sector pension plans paying about 72 cents for every dollar of investment gain they got back from hedge funds between the start of 2008 and mid-2014, according to the FT calculations.

Yet defenders of the hedge fund industry argue that many badly run or mediocre hedge funds are giving the best funds a bad name.

Some of the biggest names in the industry have continued to perform well in the years following the crisis. The problem for investors is that many of the best funds are closed to new investment, or are unavailable to anyone apart from large institutions that will place many millions into the funds.

Any potential investor in hedge funds will have to decide first whether they have found one of the few investment geniuses, as opposed to the many average managers. If they are lucky enough to have one of the former managing their money, they can expect better returns than conventional human active investment managers. But they will also have to give large amounts back in fees.

If they are not happy with such a deal they may want to follow the advice of Warren Buffett and invest in a low-cost exchange traded fund or tracker fund instead.