Hedge funds turn out not to work: average fund down 17.6% for the year

http://www.nytimes.com/2008/10/23/business/23hedge.html?em

by pg • 18 years ago

13 43 18 years ago

andr5• 18 years ago

That's not the full picture, really.

1) Since a large chunk of the money on financial markets flows between funds, and this is pretty much a zero sum game, the average hedge fund performance is bound to be around 0%, other things being equal. It's your fault if you pick the wrong hedge fund, or you don't know the risks.

2) A lot of hedge funds do not target an absolute return, but rather a return on top of the market's return (and they pick an index or several which they consider to be "the market"). So if the market is down 20%, but funds are down 17.6% on average, then they have actually made a 2.4% average return compared to the index they follow. As weird as this may sound, this is actually a success for them. They would usually get a cut of the 2.4% gains as their commission.

One of the main reasons is that absolute return funds are mostly quantitative and/or derivatives-based, and those are much harder to do than buying stocks by your gut feeling (which is what a large number of funds do, really). The other reason is that when a fund is big ($5bn+) it is very hard to move your positions around quickly (as would be required for an absolute return strategy), without shaking the market, and losing money in the process.

nostrademons5• 18 years ago

That's some pretty funny accounting.

By your first point, hedge funds are the market, and so between all of them, ought to average exactly the market returns. By your second point, they measure their returns against the market, and so on average should return 0%.

Why should anyone ever invest in hedge funds, under these premises?

A much simpler (and probably truer) explanation is "What goes up, must come down." Hedge funds booked large paper profits during the boom; now it's time for them to book large paper losses in the bust. Except that if their customers get scared, those large paper losses turn into large actual losses.

andr5• 18 years ago

Ah, but you missed the "other things being equal" part. ;) If the markets move as a whole and hedge funds are heavily long on the market, but others are market-neutral, or even short, things are not equal.

nandemo2• 18 years ago

No, 2.4% is just a relative return. In your example, the absolute return is -17.6% so the hedge fund managers won't gain anything beyond the 2% or so administration fee.

This is not a success for them or for their clients (and that is the point of HN post title!). Arguably the defining feature of hedge funds is the expectation (or claim) of positive returns independently of market conditions. In other words, they usually do target absolute returns. Otherwise there would be little basis for charging 2% of assets plus 20% of profits.

By the way, the zero sum game thing or, equivalently, average return of 0%, only makes sense if: a) compared to the average market return AND b) you consider all the "players", not only hedge funds.

charlesju• 18 years ago

Seems like that's still a pretty good investment if the market as a whole is down 40%.

pg2• 18 years ago

Stocks are down. Gold is up.

Hedge funds don't just invest in stocks. They can bet on anything, including stocks going down. This is supposed to allow them to make money in down markets as well.

andr5• 18 years ago

Hedge funds are really specialized. Usually, different people trade different things - one team on stocks (or even a narrow subset of stocks), another team on commodities, etc. It takes a lot of experience to get good at an instrument. And if your fund just doesn't have good commodity traders, you are not into gold or any other commodity.

Hedge funds are like startups, really. All of them do the same thing on paper, but some do it better, so it's your responsibility (and a bit of luck, of course) to pick the good ones.

supahfly_remix• 18 years ago

In principle, you're right.

However, hedge funds typically use a lot of leverage to make their returns, even as high as 20x. Given the credit contraction, I can see how this can kill their returns. I don't understand why someone would lend a hedge fund this money.

On a related note, I saw that K-mart advertised their "layaway" program for xmas. I hadn't heard that since I was a kid.

senthil_rajasek• 18 years ago

Gold is actually down, trading near its 52 week low

http://www.marketwatch.com/quotes/gc08z?sid=1633395

I agree that hedge funds can invest in anything (unlike MFs, which are regulated) but if you look at the short term (4-week) T-bills their interest rates are down by as much as 62% since 2002, so the general consensus is that, that is where most money is getting drained.

Why? They are the most conservative, safe investment choices available. If I may digress, this is not a good thing for the economy as we are not using that money to produce anything.

Considering the Dow is down over 30% and counting for the year, 17.6% down seems impressive to me :-)

halo• 18 years ago

>Gold is up

[Citation needed].

Everything I can find indicates that the price of gold is about the same as a year ago, while platinum has severely dropped due to lower demand from the car industry.

Dilpil• 18 years ago

This does not prove hedge funds do not work. It only proves what we already knew: active investing is a zero sum game.

This is tantamount to claiming that poker doesn't "work" because the "average" player breaks even.

hugh• 18 years ago

I assume what was meant was that they failed in their job of hedging. Hedging is supposed to involve taking a very conservative position to protect against losses.

This, I assume, is a bit of a joke since hedge funds have largely turned into speculation funds which take risky positions in the hopes of large returns.

andr5• 18 years ago

They actually succeeded in hedging, because they halved their losses compared to the market.

Hedging doesn't mean you always make money. It means that if your main instrument falls, instrument B is going to go up and cover some of the losses, but not all of them.

anthonyrubin2• 18 years ago

The recent financial reporting has been pretty atrocious.

"This unregulated, at times volatile corner of finance which is supposed to make money in bull and bear markets lost $180 billion during the last three months."

Our financial systems are heavily regulated. The specific regulations that the author would like to see may not exist, but this does not justify claiming that hedge funds are unregulated. Many people seem to believe that all risk should be regulated away and actually believe that this is possible. More information on current regulations that hedge funds are subject to:

http://www.forbes.com/opinions/2007/04/13/hedge-fund-regulat...

"Many hedge fund investors, particularly the wealthy individuals, are flabbergasted by their losses this year. The average fund was down 17.6 percent through Tuesday, according to Hedge Fund Research."

The S&P 500 is down 40% for the year.

jbrun• 18 years ago

Agreed, I would have like to be down 17.6% this year instead of whatever I am actually down. Luckily, I pulled most money out last spring to travel and start a company - best investment I have ever made!

nostrademons5• 18 years ago

I'm only down 2%. You can give me all your money and I'll invest it. Or rather, I won't, but that will save you even more money!

(And then you can curse me when we get hyperinflation, the stock market shoots up, and all that cash becomes useless.)

MikeCapone• 18 years ago

Outlawing short-selling on 900 big stocks is making it hard, to y'know, hedge..

nandemo2• 18 years ago

I beg to differ. As far as recent financial reporting goes, this is a pretty fair account. Although the financial system in general is regulated, hedge funds are unregulated as compared to mutual funds. If you want to know more about a given mutual funds, you can login to your online broker and see the prospects, asset allocation, turnover, financial statements, etc. Not so for a hedge fund. This is not to say that they're unsufficiently unregulated, it's just a statement of a fact (if hedge funds were more regulated, they'd probably cease to exist!).

Another important point is that many hedge funds are, or at least claim to be, equity-market neutral. They do it by short selling and by investing in other asset classes. So the fact that S&P is down 40% is a perfectly good excuse for a index fund manager, and a fairly good excuse for an active mutual fund manager, but not a very good excuse for a hedge fund. In fact you can see some hedge funds apologizing for the bad performance: http://dealbreaker.com/images/thumbs/TPG%20Axon%20Investor%2...

anthonyrubin2• 18 years ago

BTW Paul, why did you post this? Do you believe this drivel or were you trying to incite discussion?

maurycy3• 18 years ago

Hedge funds exploit the system, as we, hackers, do.

lacker2• 18 years ago

This article is pretty bad along with most NYT financial news coverage.

A lot of critics blame everything on deregulation. But the big banks were the most regulated part of the financial system, and they have imploded. Meanwhile hedge funds have the least regulation, and while they haven't been making money, they at least are not threatening to destroy our financial system.

The Economist had a much better article on hedge funds in the aftermath of the financial crisis.

http://www.economist.com/finance/displaystory.cfm?story_id=1...

Particularly, hedge funds have not been allowed to hedge! If the government bans short-selling in the hardest-hit stocks, don't be surprised if a hedging strategy doesn't work any more.

jimbokun2• 18 years ago

"But the big banks were the most regulated part of the financial system, and they have imploded."

I think this is not true.

It is my understanding that it was the big, less regulated investment houses that got into a lot of trouble with mortgage securities. The heavily regulated retail/commercial banks haven't suffered nearly as much.

Unless we are defining "banks" differently...?

lacker2• 18 years ago

Yeah we are defining "banks" differently - I was considering both "investment banks" and "retail banks" as types of banks. You are right that retail banks haven't suffered as much, but considering Washington Mutual and Wachovia collapsing and several others signing on to the government equity purchase program, they're definitely costing the taxpayer more than hedge funds are. So far, at least....

maurycy3• 18 years ago

It happens because there is also a silent run on hedge funds that are forced then to close their positions, bringing, even sound, assets down.

The other reason is highly leveraged funds when the margin requirements went up after interest rates raise.

bd• 18 years ago

From The Economist article:

All this means that hedge funds have been unable to ride to the rescue of global markets. According to the IMF, the average cash balance of hedge funds has risen from 14% last year to 22%, while the amount of leverage (borrowed money) they use has fallen from 70% of capital to 40%. In theory, that gives them the firepower to buy now that prices have fallen; in practice, they may need their cash to repay clients that want to redeem their holdings.

You are only as smart as your dumbest investor is.

maurycy3• 18 years ago

Means that hedge funds should hedge against their own investors, too.

mhb2• 18 years ago

Why are these things even called hedge funds? What they do is the opposite of hedging.

zandorg• 18 years ago

From the LTCM history When Genius Fails, I gather they wait for prices of equivalent bonds,stocks etc, to converge to the same value.

Okay, so a US treasury bond is equivalent to a UK treasury bond, except it's off by 0.0005%. So you buy billions/trillions of each and the price converges, and you make millions.

mhb2• 18 years ago

Well, yes. That's what arbitrage is and in what you would expect hedge funds to engage. Only they do much riskier things than that. Hence my comment.

fbbwsa• 18 years ago

obviously they DO work then, since most indices are down 40% on the year.

Hedgefunds are designed to outperform benchmark indices. Outperforming by 23% is phenomenal.

By the logic of the poster, a year where the SP500 returned 50% and a fund returned 10% would be proof that hedge funds DO work. That fund manager would be immediately fired.

Hedge funds have outperformed for the last 10 years. Taking a one year performance that loses money doesn't mean anything.

lemonysnicket• 18 years ago

So when does someone cry 'But PG, it's not hacker news!'

gojomo• 18 years ago

Circle this date in your calendars: an argumentative headline with "gratuitous editorial spin" from PG himself!

The S&P is down ~38% year-to-date; would it also follow that stocks, stock markets, or shareholder capitalism "turn out not to work"?

Wouldn't anyone in an S&P index fund rather be in one of these awful, awful "average" hedge funds? I know I would -- even just for 2008, never mind the many up years!

Hedge funds turn out not to work: average fund down 17.6% for the year

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