Despite their persistent popularity and tendency for impressive returns, hedge funds aren't all they're cracked up to be and are riskier than the average investment management industry executive might think, a group of leading financial experts claims.
After surging to the forefront during the last bear market on the dollars of ultra-wealthy investors, hedge funds now number more than 8,000. In fact, there are now more hedge funds than mutual funds, although their $1 trillion in assets still pales in comparison to the $8.1 trillion that's managed by their more traditional counterparts.
In the span of just a few years, however, the impact of hedge funds has been omnipresent. The loosely regulated investment vehicles have claimed some of the mutual fund industry's brightest managers, lured by the soaring management fees hedge funds command. In fact, the average reported income for the top 25 hedge fund managers in 2004 was $251 million, and the industry's top moneymaker reaped $1 billion.
Hedge funds have also compelled mutual funds to design products that mimic their long/short investment strategies, and at least one firm, Denver-based Janus Capital, is considering switching to the performance-based management fees used by hedge funds on some of its mutual funds.
They've also drawn the attention of regulators, who have tried to cleanse the industry of its shadier elements by imposing mandatory registration. Hedge funds, however, claim registration is too costly, so most are skirting the disclosure rule and retaining their cloak of anonymity by taking advantage of a two-year lock-up loophole.
While these factors continue to contribute greatly to the popularity of hedge funds, they also represent some of their greatest weaknesses, experts say. According to a group of 32 senior financial economists who annually examine microeconomic issues in the U.S., hedge fund fees are much too high, the performance data they provide is much too inconsistent, and the risks that accompany the typical hedge fund are much too great for them to be considered a reasonable investment option.
This news, part of a seven-page report published by the Financial Economists Roundtable, arrives at a time when hedge funds are expanding their market share by delving deeper into the nation's pool of investors.
Hedge funds-of-funds, for example, are becoming an increasingly popular way for everyday investors to get in the game. According to Hedge Fund Research in Chicago, these funds enjoyed about $388.6 billion in assets under management, or about one-third of the industry's entire assets under management, through the third quarter of 2005. Four years ago, that number stood at just $102.5 billion.
"The typical fund-of-funds investor is a high-net-worth individual, institution, public or private pension and some endowments," said Josh Rosenberg, president of Hedge Fund Research. "That's what's driving the surge."
Pension managers, in particular, are joining the fray. San Francisco-based Grail Partners estimates that pension fund flows into hedge fund products will increase 54% per year through 2010, or from $40 billion today to $350 billion. That means thousands of employees, including those from seemingly conservative sponsors like automaker General Motors and pharmaceuticals giant Eli Lilly, will be unknowingly vested in hedge funds.
"That makes us a little uneasy," said Professor Franklin R. Edwards of the Graduate School of Business at Columbia University in New York, a signatory on the roundtable report. "You have to wonder if the decisions being made by the trustees are in the best interests of the beneficiaries."
Edwards also questioned the investment acumen of some trustees, especially on smaller pensions, like local fire or police departments.
"More scrutiny should be paid to trustees," he said. "ERISA or the Department of Labor should look at what's being disclosed to the beneficiaries and what the qualifications of the trustees are."
More broadly, the report offers this warning to the money management industry: Fiduciaries for retail investors should limit their investment in hedge funds to a modest percentage of assets under management; regulators should not rescue troubled hedge funds through "bail-out" insurance, which creates further incentive for speculative behavior; and measures of performance and risk should be standardized by an independent organization, such as the CFA Institute or the Chartered Alternative Investment Analyst Association.
Numerous calls to the Hedge Fund Association seeking comment on the report were not returned prior to deadline. Inquiries at a number of hedge funds listed at the association's Web site also were not returned.
But even the most veteran of investors should tread lightly in hedge funds, added James Van Horne, a participant in the study and a professor of banking and finance at the Graduate School of Business at Stanford University.
"Investors generally know that management fees are high compared to other investment vehicles," he said. "But even sophisticated investors may not understand all the expenses and risks."
Van Horne cited incentive fees that fund managers often get for performance gains over a set threshold. The fee, which is on top of the 1% to 2% of assets fees that managers already collect annually, is typically 20% of performance gains over the threshold.
"One consequence often overlooked by the investor is the fact that when cumulative returns fall below the mark for generating fees, the general partner can close the fund in order to establish a new base for setting fees," Van Horne said.
That asymmetrical fee structure also creates an incentive for managers to adopt high-risk investment strategies, because if their investments succeed, they win big; if they fail, they lose nothing. Although investors can offset that risk by ensuring that managers themselves have a sizeable investment in the fund, the experts said that, "nonetheless, the average life of a hedge fund is just three years." The recent collapse of Stamford, Conn.-based Bayou Management is a prime example, they said.
Furthermore, the roundtable warned, the hedge fund distribution curve is unlike mutual funds. Day by day, there is a small risk that an investor could be surprised by a large loss. It's similar to what happens to currency investors when a monetary authority suddenly and sharply devalues a currency. Since this risk is difficult to measure, risk-adjusted average returns tend to be overstated, which makes it difficult to compare hedge funds to a competitive alternative.
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