No one has asked: “If hedge funds win, does anyone lose?” Yet, with the battle for alpha, (outperformance through skill-based investing) a zero sum game, the extra gains of hedge funds must be matched by resulting losses of pension funds, insurance funds, mutual funds and others. Such gains and losses could amount to $100bn (£64bn, €78bn) a year.

Hedge funds have grown from (assets of) $80bn in 1991 to $800bn in 2003 and to over $2,000bn in 2008, before falling back to $1,700bn at the end of 2009, according to data from International Financial Services. But only a minority of investors have
benefited.

The opportunities for hedge funds stem from Regulation D, introduced in 1982 under the US Securities Act 1933. This provides that funds need not be regulated if they are reserved for the exclusive use of millionaires, those with income over $200,000, and certain institutions. In the UK, access to hedge funds is limited to sophisticated investors.

Freedom from regulations has resulted in trading advantages for hedge fund managers – ability to select clients, low administrative costs, illiquidity, freedom over strategies and concentrations, unrestricted use of derivatives, unlimited leverage, the ability to go short, and close relations with prime brokers.

Data suggest these advantages have given hedge funds a performance edge. Over the period 1999 to 2009, hedge funds overall achieved annualised returns (net of fees) of some 8.5 per cent. Returns for seven principal strategies as measured by the Edhec-Risk Efficient Indices ranged from 6.5 per cent to 11 per cent; the Hennessee Composite Index returned 8.6 per cent annually, while the Barclayhedge universe saw 10.1 per cent returns.

Over the same period, returns for the FTSE All Share and S&P 500 were 3.5 per cent and 0.9 per cent respectively; those for Aon UK Fixed Interest and US Barclay Aggregate Bond indices were 4.2 per cent and 5.4 per cent. Allowing for charges on traditional funds, and possible equity/gilt mixes, annualised outperformance of hedge funds was 5-7 percentage points a year.

For a $1,700bn hedge fund industry this results in average extra gains by hedge funds of $124bn a year, and equivalent resulting losses of traditional funds. If outperformance were only 5 percentage points, the gains/losses would fall to $100bn; with 7 point outperformance they rise to $140bn.

Hedge fund industry representatives reached out to an “eminent academic”, to respond to the above. He considers hedge fund advantages are overstated; traditional fund managers can also use derivatives and leverage to some extent. In addition, hedge fund managers have brought new skills which merit higher returns. But he did not address the extent to which such skills depend on advantages available to hedge fund managers.

Alan Brown, chief investment officer at Schroders, remarks that hedge fund returns are open to question because of survivorship biases. But in its composite approach Edhec-Risk does estimate biases within particular indices, and base estimates on the principal components of several indices.

Mr Brown suggests that as hedge funds grow their managers will be less able to outperform. Moreover, some mutual fund managers are moving away from a benchmark-focused approach, in order to compete more effectively with hedge funds.

Cass Business School professor Andrew Clare points to recent US research (Dichev and Yu) suggesting hedge fund investor returns could be below fund returns. Investor returns reflect timing and magnitude of capital flows into and out of funds, and these are below fund returns, measured assuming a buy-and-hold approach. But the same applies to mutual funds, though apparently less so.

Such comments cast doubt over effective outperformance of hedge funds. But even at 3 per cent, hedge fund gains from traditional funds could average $60bn a year. If the industry returned to 2008 levels, the figure would approach $100bn.

Some might claim that hedge funds improve market efficiency and so raise beta for all investors. But the real efficiency benefits may be limited. Hedge funds did little to correct prices in the high-tech bubble, for instance. The disruptive effects of hedge funds, for example through deleveraging and mass selling in the 2008/09 crisis, have also to be taken into account. Furthermore, if there are net effiency benefits it is not clear these will lead to market rises and more beta rather than market falls.

Given that authorities have allowed a minority significant trading advantages, those with resulting losses could claim to be victims of licensed robbery. Authorities could respond that the less well-off needed the protection, but there are no obvious examples of selective regulation leading to a minority gaining perhaps $100bn a year from others.

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