Arne Alsin: Smart hedge funds that capitalise on dumb money

“Dumb money” is a pejorative label commonly used to describe uninformed or misguided investors. Unfortunately, this label applies to many hedge fund investors who have poured money into hedge funds, with assets more than doubling over the past five years to more than $1,500bn.

If people carefully considered the structural deficiencies of hedge funds before investing, most would never invest. Hedge funds are not designed to serve the best interests of investors. They are designed to serve the best interests of hedge fund operators.

What are the attributes that should make investors wary?

First, lack of transparency: hedge fund investors are at a significant information disadvantage compared with investors in other instruments. For example, the owner of a brokerage account can go online and see exactly what he or she owns and how much it is worth at any hour of the day, on any day of the year.

Hedge fund investors cannot see how their capital is being allocated. Since they cannot see how their capital is positioned and how much debt leverage is used, there is no way for a hedge fund investor to gauge risk. The net result is a characteristic common to each and every hedge fund catastrophe. That is, the investor is the last to know.

Imagine if companies reported only earnings per share and did not provide investors with cash flow, income statements or a balance sheet. Imagine if a chief executive said that, for competitive reasons, everything needed to be kept secret: that only earnings per share would be disclosed. That is the essence of how hedge funds behave.

Hedge fund managers are quick to rail against companies when they think pertinent information has been withheld. They rightly claim that management has a duty to the owner/ shareholders to provide them with full information. It is ironic that the same hedge fund managers provide their owner/investors with woefully incomplete data.

Hedge fund operators expect investors to be satisfied with rate of return data and, perhaps, some accompanying commentary. But, by itself, hedge fund performance data is meaningless. Rate of return data have meaning only if you understand how they were arrived at.

It is a mistake, for example, to be impressed by a hedge fund that claims to have generated returns of more than 40 per cent annually for three consecutive years. An informed judgment cannot be made solely based on a nominal rate of return. Does the fund use a lot of leverage? Are there illiquid or hard-to-value holdings? Does the fund set aside holdings in side pockets? Does it invest in speculative securities? Is there exposure to derivative contracts?

After it was formed in 1994, Long Term Capital Management posted annual returns of more than 40 per cent until it collapsed in 1998. The fund employed leverage that exceeded, at times, 30 times equity. With that much leverage, it should come as no surprise that $3.6bn of equity capital was wiped out in just five weeks.

Further, hedge funds have a misaligned incentive structure. The typical hedge fund charges at least a 1 per cent annual management fee plus 20 per cent of profits. This fee arrangement is aligned nicely to a hedge fund manager’s objective of getting rich. It is not aligned with investor goals such as long-term wealth accumulation or funding retirement.

The misaligned incentive system opens up the potential for all sorts of investor abuse. Consider the asymmetrical consequences for a hedge fund manager that leverages investor capital to speculate on a 50/50 proposition. If it pays off, the manager gets a windfall equalling 20 per cent of profits while placing none of his own capital at risk. If it does not pay off, all the loss is borne by the investor.

The incentive fee structure can also enrich hedge fund managers who ultimately lose all their investor’s capital. For example, many of the hedge funds that have collapsed in recent months generated high rates of return in prior years. Investors then paid fees of at least 20 per cent of annual profits to the managers. And now, post-blow-up, the investors are left with little or no capital left in their accounts.

Last, hedge funds lack accountability. Because the industry is unregulated, any and all information promulgated by hedge funds should be viewed with caution. Without regulatory scrutiny and without disclosure about how returns are generated, investors have a right to be sceptical.

Performance tables that suggest the hedge fund industry produces competitive returns should be viewed with suspicion. Survivorship bias is one factor. About 7 per cent of hedge funds disappeared in 2006 and, presumably, many more will disappear this year. Performance tables do not disclose how much leverage was used to generate the returns. Implicit in the performance tables, also, is the assumption that valuation of derivative contracts and a wide variety of other illiquid assets is fair and reasonable. That may not be a safe assumption.

The writer is a portfolio manager for Alsin Capital and the Turnaround Fund. arne@alsincapital.com