The Cocktail Party Fallacy

There is big money to be made in hedge funds – if you run one, that is.

A good proportion of the investing public—egged on by the financial media—genuinely wants to believe that consistent market-beating returns are achievable without taking on additional risk and paying excessive fees. Many of them have come to link hedge funds with an exclusive cachet – one that they can throw out to their friends at cocktail parties with a sound of great import and sophistication. With this in mind, here are some main points to keep in mind should someone come calling with a “new” hedge fund strategy that is full of enticing promises.

Hedge funds are not an asset class but a compensation structure.

The investment community often speaks of hedge funds as if they were an asset class—that is, a collection of securities with common variation to macro risk factors (e.g., large-cap stocks, small-cap stocks, international stocks, bonds, etc.). The industry has advanced the asset class idea by further refining hedge fund descriptions and inventing a convoluted set of names to describe specific strategies, such as convertible arbitrage, global macro, distressed securities, merger arbitrage and market neutral. All of the funds are completely different in structure, strategy and risk. Because they can behave so differently, hedge funds cannot be classified as a specific asset class because they do not have a similar risk/return profile. While there is evidence that some of these strategies can add value and help further diversify a portfolio, when you couple them with high fees, lack of liquidity and transparency, any benefit largely disappears.

The most common compensation structure in the hedge fund business is the so-called “two and twenty,” where the manager charges a two percent annual fee and receives 20 percent of profits. This fee structure, which has produced astronomical manager compensation, is one of the stark dividing lines between hedge funds and mutual funds. From a marketing perspective, the appeal is fairly evident. After all, the more exclusive you make a club, the more likely people will pay a premium to join it.

The available data on hedge funds are far from perfect.

Hedge funds are currently under no obligation to disclose their results. Consequently, hedge fund databases are of very low quality and are filled with backfill bias (managers only report after they have good performance) and survivorship bias (data vendors only supply data on funds that are still in operation). These two factors can compromise any analysis of hedge fund returns, with some studies concluding that survivorship bias alone overestimates returns by two to four percent and underestimates risk by 10 to 20 percent.

The scarce resource captures the rents.

Let’s assume one can identify manager skill in the world of alternative investments. Who is likely to benefit from that skill, investors or the skillful hedge fund manager? A fundamental principle of economics is that the scarce resource captures the rents. While there is an abundance of capital flowing into various investment strategies around the world, manager skill that is both persistent and easy to identify (in advance) seems in short supply. As Professor Kenneth French has frequently noted in much of his research, if the manager’s skill is the scarce resource, he will likely capture the rents by either raising ever larger sums of money to invest, or by increasing his fees—or both.

A manager who has successfully pursued a strategy that is capacity constrained and cannot be exploited with larger sums of money would effectively dilute the results of all his investors should he choose to keep the fund open to new money. However, closing the fund to new investors also limits the manager’s ability to be remunerated for actual skill. As an alternative, the manager might choose to close the fund but increase fees. Either way, rents go to the scarce resource—manager skill—and not to the limited partners who supplied the capital.

While the hedge fund industry no doubt would contest the findings of many academic papers that have come to critical, damning conclusions – you don’t have to agree with the numbers to harbor reasonable doubts about risking your hard-earned savings by investing in hedge funds.

So the next time you overhear the neighbors or a friend bragging about their hedge fund investments – remind them that the odds and fees are almost certainly stacked against them. Then suggest that the wiser course might be to start their own hedge fund.

The bottom line remains unchanged: Hedge funds are one of the best vehicles ever created to transfer wealth directly from investors’ wallets into the managers’ pockets.