Despite all the media coverage, glitz and glam of hedge funds, they have not done well for their investors. They have high — some say excessively high — fees; their short- and long-term performance has been poor.
Before delving into the details, let’s define exactly what we are discussing: Hedge funds are private investment partnerships. The general partner is typically the fund manager (on occasion it includes his financial backers). The investors in the fund are the limited partners, normally institutions and accredited investors. This partnership structure typically has a max of 99 limited partners. Unlike mutual funds or brokerages, hedge funds are mostly unregulated.
The global hedge fund industry manages $2.13 trillion, or about 1.1 percent of all assets held by financial institutions, according to the Coalition of Private Investment Companies. Given what a relatively small asset class this is, hedge funds certainly receive an excess of media attention. Many hedge fund managers have become billionaires; perhaps this — plus their reputations as the smartest guys in the room — is why they have captured the investing public’s imagination.
Most hedge funds are “go anywhere” funds — they can own derivatives, mortgage-backed securities, credit-default swaps, structured products and illiquid assets. They also can use nearly unlimited leverage.
Gee, that sounds kinda hazardous. Why would anyone want to assume all of that risk? Originally, hedge funds earned their outsize compensation by, well, hedging their investments. This is a risk-mitigation strategy that can reduce the gains investors reap when markets are up but avoids much of the losses when markets are down.
That no longer seems to be the case with modern hedge funds. They have morphed into “absolute return” funds — more aggressive, greater leverage, more speculative, all in an attempt to generate returns that outperform their benchmarks. Not surprisingly, they have become riskier than the overall market.
Given these increased risks (and higher fees), how have hedge funds performed?
By most measures, not well. They have failed to keep up with major averages when markets were up — and they got mangled (like nearly everyone else) during the 2008-09 downturn. It turns out, most hedge funds are not very hedged.
The latest performance data (via the HFRX Global Hedge Fund Index) reveal that hedge funds haven’t fared well at all: They returned a mere 3.5 percent in 2012, while the S&P 500-stock index gained 16 percent. Over the past five years, and the hedge fund index lost 13.6 percent, while the indices added 8.6 percent. That’s as of the end of 2012; it has only gotten worse in 2013. Most hedge funds have fallen even further behind their benchmarks this year, gaining 5.4 percent vs. the market’s rally of 15.4 percent. As a source of comparison, the average mutual fund is up 14.8 percent.