On June 17th, Forbes writer Liyan Chen wrote, 20 Stocks The Richest Hedge Fund Managers are Buying And Selling in 2015 Q1. “ To compile the list, we looked at the U.S. trades of billionaire hedge fund managers in the half-year ending March 31.” One stock she highlighted was SunEdison, the world’s largest renewable-energy development company. Ms. Chen poled 21 big hedge fund managers. Ten of them were loading up on the energy giant. By far, it was the most popular stock profiled.
She also mentioned the stock that the managers liked the least. “Eleven top managers lowered their stakes in American Airlines Group in anticipation of the airline industry’s overcapacity.”
Forbes published the article just 2 months ago. As of September 4th, a $10,000 investment in SunEdison would have dropped to $4,023. These managers should have bought what they were actually selling or shorting. An equal investment in the ugly duckling, American Airlines Group, would have risen to $10,210. Poor bets like these can cause hedge funds to languish. Fees make it worse.
Hedge funds usually charge a 2 percent annual management fee. Managers also take 20 percent of any profits made by the fund. So if the fund earned 10 percent before fees, managers would take 2 percent of the assets. That leaves just 8 percent. But the gouging isn’t finished yet. Next, managers take 20 percent of the 8 percent that’s left. So if the fund earned a 10 percent gain before fees, the investor would make just 6.4 percent.
Let’s assume, for a moment, that these Masters of the Universe worked for free. Sure this sounds silly. Nobody runs a hedge fund to make the world a better place. But roll with it for a moment. Assume they don’t take 2 percent of the assets each year. Assume they don’t take a percentage of the investors’ annual profits.
Would the typical hedge fund beat a simple Couch Potato portfolio? Let me introduce the Couch Potato first. It might be the world’s simplest portfolio. Rebalanced once a year, it comprises half of its assets in Vanguard’s Total Stock Market Index (VTSMX). The other half goes into Vanguard’s Inflation-Protected Securities index (VIPSX). It’s a simple combination of stocks and bonds. Expenses are just 0.19 percent a year.
Between January 2003 and September 2015, the typical hedge fund averaged a compounding return of 0.94 percent per year after fees. You can find their results at hedgefundresearch.com. By comparison, the Couch Potato portfolio averaged 6.3 percent.
HFRX Hedge Fund Index vs. The Couch Potato Portfolio
January 2003 to September 2015
Average Annual Returns
|HFRX Hedge Fund Index||Couch Potato Portfolio|
|Sources: hedgefundresearch.com; The Head Fund Mirage, by Simon Lack; Morningstar.com|
You don’t need a financial calculator to figure out that the typical hedge fund investor would have made more money with a Couch Potato portfolio—even if they hadn’t paid a penny in hedge fund fees.
Reality could be worse. After fees, most hedge fund investors earned even less than 0.94 percent per year.
Hedge funds aren’t registered with the Securities and Exchange Commission. Fund managers can report their results to the reporting services whenever they’re in the mood. They can also stop reporting whenever it suits them. When results are strong, they report results. This allows them to attract more client investment money. The increased assets under management balloon managers’ income.
But when results are weak, managers keep quiet. Many won’t report their results. Nicolas P.B. Bollen and Veronika K. Pool outlined this abuse in their American Finance Association publication, “Do Hedge Fund Managers Misreport Returns? Evidence from the Pooled Distribution”
The upward bias on reported returns is even uglier when we see how many hedge funds go out of business. Princeton University’s Burton Malkiel and Yale School of Management’s Robert Ibbotson studied Hedge Funds from 1996 to 2004. During the study, 75 percent of them went out of business. Only funds that remain--and voluntarily report their results--are used for data compilation. As a result, Malkiel and Ibbotson calculated that the average returns reported in data bases were overstated by 7.3 percent annually during their eight year study.
As for those headlines reporting what hedge fund managers are buying right now. Don’t even bother to click.
Andrew Hallam is a Digital Nomad. He’s the author of the bestseller, Millionaire Teacher and The Global Expatriate's Guide to Investing: From Millionaire Teacher to Millionaire Expat.