The Berkshire Hathaway chairman Warren Buffett once famously quipped that a hedge fund is a “compensation scheme masquerading as an asset class”. The remark, a reference to the fact that many hedge funds provide investors with feeble returns whilst massively enriching intermediaries (the hedge fund managers and 'prime brokers') at investors’ expense, is even more true today than when Buffett reportedly first said it last decade.
Given their very patchy performance since the crisis got underway in 2008, one might have thought that hedge funds would be suffering from massive redemptions right now. However this is not the case. Recent figures from Hedge Fund Research suggest that global investors, including the likes of charities, endowments and pension funds, pumped a net $70bn into the hedge fund sector during 2011, a significant rise on the net inflows of $55bn seen in 2010.
The sector ended 2011 on a high note, with total assets once again breaking back through the $2 trillion mark. This suggests that, even in a worst case scenario of flat or negative returns in 2012, the world's hedge fund managers and hedge fund management firms can expect to earn (or "gouge"?) some £40bn from their investors in fees this year.
Investors enthusiasm for the compensation scheme is all the more surprising given the woeful aggregate performance across the sector over the past 12 years. In The Hedge Fund Mirage, just published by John Wiley & Sons, Simon Lack, who spent many years evaluating hedge fund performance at investment bank JP Morgan Chase, reveals that the effective return to hedge-fund clients since 1998 has been only 2.1% a year, which represents 50% of what could have been achieved by investing in US Treasury bills.
Paul Amery, editor of Index Universe, said that despite offering a “heads I win, tails you lose” bet to their clients, and even though the average hedge fund actually lost 5% during 2011 (according to figures from Boston-based State Street) investors and their agents just can't keep themselves from falling for the hedgies' hype.
Also citing research contained in The Hedge Fund Mirage, Amery points out that in the 12 years from 1998 and 2010, hedge fund managers 'earned' $379bn in fees, out of total investment gains (before fees) of $449bn. So hedgies and hedge fund management firms have somehow engineered a situation in which 84% of the investment profits of their funds go straight into their own pockets, leaving a meager 16% for end-investors. It's an egregious example of the “agency capitalism” (where intermediaries skim off most of the investors’ gains for themselves) that I described in earlier QFINANCE blog posts, that seems even more egregious given that speculative activity by hedge funds has fuelled commodity and energy inflation.
The principal-agent problem is no less rife and value destructive in the private equity sector. Fund managers in the sector enjoy a very similar "two and twenty” fee structure to their peers in hedge funds, but with the added advantage of “tax breaks thrown in”, said Amery.
And the overall performance of private equity funds has lately been very weak. After fees, the returns from private equity investments have barely risen above the performance of the S&P500 index, according The Economist – and returns have been further enfeebled since the 2008 demise of the highly-leveraged buyout.
Writing on Slate’s Moneybox blog Matthew Yglesias confirmed that, like hedge funds, private equity meets Buffett’s dictum of being “a compensation scheme dressed up as an asset class”. He quoted a Financial Times article of January 23 which said:
"Private equity has proved better at enriching its own managers than producing investment profits for US pension funds over the past decade, according to a study prepared for the Financial Times by academics at Yale and Maastricht University. [...] From 2001 to 2010, US pension plans on average made 4.5% a year, after fees, from their investments in private equity. In that period, the pension funds paid an average 4% of invested capital each year in management fees. On top of those, private equity often collects a variety of other fees and a fifth of investment profits."
Yglesisias said these alternative asset classes had worked pretty well for investors in their youth and middle age. But now they have reached their dotage, and since the seismic shifts in the market since the dark days of 2008, which have made leverage scarcer and more expensive at the same time making highly-geared models less acceptable to more vigilant and loss-bearing capital obsessed regulators, means the game may be up for the alternative asset classes. He wrote:
"You can easily imagine telling a story in the 1980s about how the brand-new innovation of leveraged buyouts is able to exploit long-simmering market inefficiencies and reap gigantic returns. But once the asset class becomes mature, all the low-hanging fruit has already been picked and you're left with the same basic problem as in any effort to beat the market."
What astounds me is that the principal-agent problem -- a long-running sore for customers of the finance industry (i.e. the end investors are effectively getting 'fleeced') -- is that neither end-investors, their representatives as in pension funds such as trustees, nor regulators have shown much sign of taking serious steps to address it. The only organisation that is making any real headway in attacking the vested interests which are denuding us of our pensions seems to be Fair Pensions
Amery, who took to journalism after a 20-year career in financial markets where he worked for Schroders, Cargill, ING and Insight, concluded his "Beware of rigged bets" piece by saying:
"With reforms bogged down by lobbyists and overshadowed by the debt and euro crises,
politicians and regulators are far from addressing the root causes of the agency problems that still beset the whole financial sector."
Further reading on the value offered by hedge funds and private equity:
- I didn’t do it! The hedge funds did! by All About Alpha
- Carrying Out Due Diligence on Hedge Funds by Amarendra Swarup
- Carrying Out Due Diligence on Private Equity Funds by Rainer Ender
- Hedge Fund Challenges Extend Beyond Regulation by Kevin Burrows
Tags: alternative assets , Cargill , Fair Pensions , Financial Markets , Hedge Fund Research , hedge funds , Index Universe , ING , John Wiley & Sons , Matthew Yglesias , Paul Amery , private equity , rent gouge , Schroders , Slate , The Economist , The Hedge Fund Mirage , Warren Buffett