An Academic Response to the 'Hedge Fund Mirage'

Despite the seeming demand by investors for hedge funds, critics of the hedge fund industry still often attempt to prove that hedge fund investors have been sold a product that has not provided real benefits to investors in the past. These critics often paint the hedge fund industry with a broad brush of poor performance and often maintain that the rise in assets under management (AUM) in the hedge fund industry could therefore only be accomplished through a range of investment scams or marketing trickery. Given the sophistication of the investment industry, even in an imperfect information market, the very fact that over the past twenty years AUM in the hedge fund industry has reportedly grown from under $100 billion to over $2 trillion is indicative that many investors view the strategies which are included under the hedge fund umbrella as beneficial in their expected return/risk management decisions. In a recent book, titled Hedge Fund Mirage, the author expresses concerns over the potential benefits of hedge funds and maintains that the picture of hedge funds benefiting the average investor is biased by the fact that the superior performance of hedge funds was mainly achieved in the 1990’s when hedge funds had fewer investors (at least as measured by industry AUM). The author maintains that if we used AUM based performance measures, the average investor’s relatively lower performance in recent years in which hedge fund AUM has been high would dominate superior hedge fund performance in earlier low hedge fund AUM years. The author of also cites the fees charged by hedge fund managers as a potential source of low hedge fund returns and maintains that, over the period of his analysis, investor’s yearly real profits were dominated by hedge fund managers’ profits. Of course, good theater is not always based on good facts. This book has to fit under the classification, “interesting if true” in that while some of its concerns are valid, many of its conclusions are not true. In this brief report, we provide additional analysis of the benefits of hedge funds over the period of analysis. We argue that if one uses any of the more traditional hedge fund indices (including both Equal Weighted and Asset Weighted Hedge Fund Indices) while using the internal rate of return (IRR) method and benchmark comparison (risk free rate) suggested by the author, it can be shown that even using the IRR suggested by the author, all of these widely used hedge fund indices had IRR greater than the comparison risk free rate. In addition, if one uses any of the widely used hedge fund indices as well as the book’s own preferred HFRX Global Asset Weighted index, it can also be shown that using more traditional return measures in almost every year hedge funds are beneficial when added to a traditional portfolio of stocks and bonds. In short, using author’s suggested IRR/AUM based performance methodology and suggested risk-free rate benchmark, results based on widely used hedge fund indices show the long term benefits of hedge funds. Moreover, if one has concerns as to author’s methodology for judging the benefits of hedge funds, results based on more traditional return methodologies also show that looking at hedge fund benefits on a year by year basis further indicates the benefits of hedge funds over the period of analysis; that is, a hedge fund benefits ‘win/win’ under either analytical approach.Lastly, the author also raises the issue of hedge fund manager profits as a source of market concern. To some, the positive benefit of hedge fund as additions to a sample stock/bond portfolio in every year of this analysis makes the gross profit of a hedge fund manager moot. This is up to one’s personal opinion. Regardless of the product, (financial, consumer, manufacturing), if an investor is receiving a positive benefit from owning a product, the net profit to the creators of the product may be regarded of secondary concern. More importantly, what is presented in the book is not ‘net profit’ to hedge fund managers but ‘gross profit’. Any discussion that concentrates on the gross profit of a hedge fund manager is meaningless. Gross profits are a measure of gross revenue. In order to determine actual net profits to a hedge fund, one must remove all costs (operational, research, staff, travel, research…). Only then can one compare net profits to investors with net profits to hedge fund managers and the relative returns to each. This is impossible to do without detailed fund operational cost data. Again, gross profits as a measure of returns to hedge fund manager does not and cannot represent the actual profits to a hedge fund manager any more than gross revenue to a corporation represents the net profits to the firm. The author of “Hedge Fund Mirage” does not have the net profits to hedge funds but such data is required before true comparisons between net profit to investor and net profit to hedge fund manager can be made.There are many other issues discussed in “Hedge Fund Mirage”, some of which such as the benefits to investors of increased transparency are valid concerns. It is a little disheartening that the good of the book is mixed with the ‘false’ theatre of poor hedge fund performance and excess hedge fund manager profits.