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The Hedge Fund Mirage: The Illusion of Big Money and Why It's Too Good to Be True ReviewThis is really two books. Chapters 2 - 8 are a clear, detailed and accurate discussion of how and why to invest in hedge funds. The author weaves anecdote, simple examples and common sense into an entertaining and informative guide. It requires no financial or mathematical sophistication to follow, but it delves into important details that too many investors neglect. These chapters would make it a worthy companion to John Bogle's great Common Sense on Mutual Funds. Much of the message is the same: pay attention to fees, expenses and tax efficiency; do business with honest people; understand the product; have reasonable expectations; be prepared for losses; keep a steady course.
Unfortunately, these chapters are bookended by sensational nonsense. The calm expert who understands hedge funds is replaced by an idiot trying to get attention. It's not so much that the wild claims are wrong, it's certainly true that many--even most, depending how you count--hedge funds charge too much and fail to deliver the promised investment characteristics. The problem is that in his effort to overhype the evidence, the author gets things completely wrong (Chapter 1) which leads to some foolish advice (Chapter 9).
To start, the author explains the difference between time-weighted and value-weighted returns. An investor puts $1 million in a fund that has a +50% return, he adds another $1 million, the fund then has a -40% return. Net, the investor has lost 25% of his money. The fund will report a compound average annual growth rate of negative 5.13%. The investor lost more than that (25% over two years or negative 13.40% CAGR) because he put more money in for the bad year than the good year. But the author makes the crazy claim that the fund will report a positive 5.13% compounded annual return: a math error that fuels a couple of pages of rant about funds making money when investors lose.
The author moves on to apply this example to the history of hedge fund returns since 1998. He claims returns were good at the beginning because funds were small and nimble, but got bad in later years because too much money flowed in. Although returns were great for a buy-and-hold investor who got in in 1998, the average investor got in later and had positive but unexciting returns as a result. The story may or may not be true, but the evidence doesn't have anything to do with it. The reason returns were unexciting for the average investor is that she got into hedge funds in 2007, just before the only money-losing year. But she would have done far worse if she'd kept her money in stocks in 2008. Of course, she would have done better keeping her money in cash in 2008 than putting it in the average hedge fund, but if she could predict the future that well she'd have put all her money with John Paulson. The most dramatic claim in the book, that the average hedge fund investor would have been better in in treasury bills from 1998 to 2011, is just false, another math error. Using his numbers, hedge fund investors put $1.24 trillion into funds over the period, and have $1.78 trillion to show for it, a 44% return over an average investment period 8 years. The same investments in t-bills would have been worth $1.52 trillion at the end of 2010, a 23% return, just over half the hedge fund result.
The bigger error is this kind of comparison misses the entire point of most hedge funds. A market-neutral fund is not designed as a stand-alone investment, but as a diversifier for an equity portfolio. It can have half the return of equities with the same volatility, and still be valuable. The question isn't whether putting 100% of your money in hedge funds did better than putting 100% in stocks, it's what portion of assets an investor should allocate to hedge funds. Using the author's own numbers, an investor would have done best to have 30% of assets in hedge funds, rebalancing annually, from 1998 to 2010. That produced 4.2% annual alpha (return in excess of what you could have gotten investing in stock index funds and t-bills with the same volatility). That number is certainly overstated, hedge fund investors typically do worse than the index suggests, but it demonstrates that you can't consider only stand-alone returns. This point is borne out by the finding that endowments and pension funds that make use of hedge funds have consistently better risk-adjusted performance than those that do not.
Another outrageous error is to define "absolute return" funds as ones that do not generate negative returns, that is, that never lose money. That's absurd of course. Absolute return funds are ones that do not benchmark their returns. A typical stock mutual fund attempts to outperform the overall stock market, but makes no representation about overall market returns. If the stock market goes down, the stock mutual fund expects to lose money. An absolute return fund attempts to make positive returns in all market environments. That doesn't mean it never loses money, it means it's equally likely to lose money when the stock market is up as when it is down.
The problem is not that the author has chosen to make sensational claims, presumably to get attention for his book. It might even help investors to be scared, they might pay better attention to the good advice following. But the errors in Chapters 1 and 9 can cause deep confusion: funds report positive returns when investors lose money, hedge funds should be evaluated as stand-alone investments, absolute return funds never lose money. And this leads to silly advice for most people in chapter 9: search for tiny start-up hedge funds and try to get great returns. For almost everyone it makes sense instead to consider adding some established, low-fee, low-risk hedge funds to a diversified portfolio, trying to get uncorrelated returns for long-term risk-adjusted performance rather than home runs for instant riches.
Disclaimer: I work for a hedge fund but I actually have a worse opinion than the author of the average hedge fund. I don't object to bashing hedge funds, but it's important to bash for the right reasons.
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