Of course "hedge funds" lose money

Matt O'Brien, one of my partners-in-crime over at the Atlantic, has a piece criticizing hedge fund managers who go on TV to advocate hard-money policies. (Joe Weisenthal has a similar piece.) I agree with the criticism. But Matt also calls hedge fund managers out for their poor investment performance. As this article from The Economist shows, super-expensive hedge funds have done terribly over the last decade, when compared with a simple low-cost diversified portfolio of stocks and bonds. Matt says: "Hey hedge fund guys, if you can't even beat the market, why should we trust you on policy issues?"

I think this latter criticism is a bit misplaced, for two reasons. The first (and less important) reason is that to evaluate hedge funds - or any investment - you need to look not only at the return, but at the risk. If hedge funds have higher return-to-risk ratios (such as Sharpe ratios) than a passive stock-bond portfolio, then they are a better investment. Why? Because in that case you can borrow money and invest it in hedge funds, and your leverage will increase the returns (and the risk) of the hedge fund investment. If the hedge funds have a higher Sharpe ratio than the passive portfolio, you can leverage up until your risk is the same as the passive portfolio but your return is higher. In that case, you will have beaten the market, even if the hedge funds in which you invested did not beat the market. A number of top hedge funds have earned lower returns than the market since the financial crisis, but with much lower risk.

See?

Now, I said that this is the "less important" reason. This is because even after adjusting for risk, hedge funds as a class probably underperformed the market. And they can be expected to continue to underperform the market, as a class. But that's just because hedge funds as a class are not particularly special, interesting, valuable, or desirable.

What is a "hedge fund"? It's a legal category, like "mutual fund". The "hedge fund" category is basically a "none of the above" legal category, meaning that hedge funds, alone among money management companies, have essentially no restrictions on the kinds of assets they are allowed to trade. To start a hedge fund, all you have to do is be a "qualified investor" with $5 million in capital, or be a "sophisticated investor". That means that as a hedge fund you can be essentially any Tom, Dick, or Harry, and you can try essentially any strategy. You could have macaque monkeys pick stocks and call it a "hedge fund". The catch-all "hedge fund" category attracts many of the best ideas in the investing world, but also many of the worst. And there's a lot more bad ideas than good ones. And you can't just tell which is bad and which is good by looking at size and fame, because many of the bad ones get lucky and get some temporary good returns, which results in people handing them giant wads of cash (which they then proceed to lose, while taking a giant fee).

Thus, just throwing your money at anything that is called a "hedge fund", just because you have heard that some "hedge funds" have managed to earn spectacular returns, is an extraordinarily bad idea.To put it another way: Anthony Scaramucci, organizer of the SALT hedge fund conference in Las Vegas, writes: "Mutual funds are the propeller planes, while hedge funds are the fighter jets." But that's not true. Some of them really are fighter jets. And some of them are beat-up old pickup trucks covered in papier-mache to make them look like fighter jets from a distance. And you aren't allowed to get anywhere near the planes to touch them and see which is which. And you forgot your glasses.

Anyway, I'm sure many rich people do invest in anything called a "hedge fund", but they're just throwing their money away (fortunately they have plenty to spare). But if America's pension funds, mutual funds, and insurance companies are doing this, then we have a problem.

In any case, we shouldn't be surprised that hedge funds as a class have been getting crappy returns of late. In fact, we've seen this sort of pattern before. In the 1990s, "venture capital" firms earned amazing returns, and a bunch of people heard about it and started throwing their money at anything that called itself a "venture capital" fund. New funds flooded the field to take advantage of this inflow of dumb money. Returns subsequently collapsed and have not recovered, though the old established firms continued making outsized returns (but stopped taking new investments, because when you get big it's harder to grow fast). The same thing happened with "private equity" (leveraged buyout) firms, who made a killing in the 00s but have not been doing so well since. And the same thing probably happened with mutual funds, back in the 60s when they became prominent and earned a lot of money.

So there is a very interesting behavioral story going on here. Why do people hurl their money blindly at the flavor-of-the-week money-management company category? Why do they fail to understand that there are good and bad hedge funds, just like there are good and bad architects or doctors or web designers? I don't know, but it's a fertile topic for behavioral finance research.

(And as a final note, the big worry when investing in hedge funds should probably be fees, not past performance. Even the best hedge funds may charge you such high fees that the extra returns they earn you get eaten up. So watch out.)

Back to the original subject, though. Matt shouldn't castigate "hedge funds" as a whole for making crappy returns, because it's just a legal category, not a hive mind. But his basic point stands anyway. You shouldn't trust hedge fund guys on policy issues. In fact, he even understates his case. Even if a hedge fund guy makes more money than God, year in and year out, you shouldn't trust him on policy issues any more than a highly successful physicist or heart surgeon or poker player. A money management company is not a nation-state.


Update: On Twitter, Giorgio Vitale brought to my attention the fact that the graph Matt shows is not actually hedge fund returns (those are often undisclosed), but the returns on an index that tries to track broad hedge-fund performance. That's good to know, though my points all still apply...