Rich managers, poor clients

why you should be careful choosing hedge funds to invest.

an article from economist.

THE masters of the universe have been humbled. Over the past ten years, hedge-fund managers have underperformed not just the stockmarket, but inflation as well. After fees, investors in the average hedge fund have received a return of just 17% (see article). Where should investors now look for zippier returns?

The mediocrity of the hedgies’ recent performance is in part the result of the industry’s massive growth. Whereas in the past it was plausible that hotshots like George Soros could spot market anomalies, several thousand managers in an industry with $2 trillion of assets under management are very unlikely all to be able to earn spectacular returns. There will always be a few managers who do well, of course, but there is no reliable way of identifying them in advance, and past performance is a poor guide to future returns. John Paulson, the manager who made a fortune out of the subprime-mortgage crisis, has performed dismally since the start of 2011.

But these vehicles pose a more fundamental problem for investors. Managers of hedge funds charge a lot more than those who run conventional mutual funds, and many times more than those who offer funds that track stockmarket indices. Hedge-fund fees are usually 2% every year, plus 20% of all returns over a set level. It is, as a result, easy to think of people who have become billionaires by managing hedge funds; it is far harder to think of any of their clients who have got as rich. Fund management has become like films or professional sport: a much more lucrative business for the insiders than for those who stump up the cash to pay them.

The lowdown

No one can know for certain what future investment returns will be. If the writers at The Economist were sure of the answer, they would be lounging about on their luxury yachts instead of sweating over split infinitives. But the signs are that returns are likely to be decidedly modest. The best estimate for the future return on cash and government bonds is the current yield and, in most developed markets, that yield is at, or close to, an all-time low.

Equities might well perform rather better than bonds over the coming decade, but caution is in order there too. The reason that rates and bond yields are so low is that central banks remain extremely worried about the economic outlook. If the regulators are right to be troubled, then it will be hard for corporate profits to grow in coming years, especially in countries (such as America) where profit margins are already at multi-decade highs. And if central banks’ worries are misplaced, that means they have got monetary policy wrong, so there will be other problems for companies, such as inflation.

Perversely, it has been the poor performance of equities and bonds over the past decade that has maintained the allure of hedge funds for institutional investors such as pension funds. Investors have been hoping that the industry will act as a deus ex machina and help them reduce the stubborn deficits in many pension funds. It has not—and probably will not.

If the outlook for returns in both equities and bonds is subdued, investors should concentrate on the one factor they can control: costs. When hedge funds were returning 10-30% a year in the 1990s, their fees made less of a dent in clients’ returns than they do now. If they are the investment equivalent of Harrods, investors now need to shop in the likes of Walmart or Lidl: exchange-traded funds (ETFs) and index-trackers.

Even these come with a health warning. Some cheap funds are cheaper than others: in Britain, for example, HSBC’s equity tracker fund has an expense ratio of 0.27% a year, whereas Virgin’s equivalent fund charges a full percentage point. Some ETFs do not invest in the securities they claim to track, but in derivatives contracts with a bank counterparty. That adds an extra layer of risk.

The best way for investors to play the odds is to choose low-cost ETFs or trackers and diversify geographically and across asset classes. It is not an exciting strategy. It will not bring anything to brag about at dinner parties. But it will mean that more of their money stays in their own pockets, and less goes to buy other people’s mansions in Mayfair and the Hamptons.