Caveat emptor on hedge funds

16 Jul

Monday’s Financial Times contains an important piece on the hedge fund industry – see It quotes one academic study as showing that ‘investors earned just 36 cents for each dollar in gross profits generated by the funds above the benchmark, the other 64 cents being collected by hedge fund managers’. It would seem that the people making money from hedge funds are the owners of the funds rather than the average investor.
This has some similarities with the debate on indexed fund management. Over 20 years ago, when I was working at PwC, we did a study for Barclays Global Investors, which showed that, for large cap stocks, the average active fund manager underperformed against the benchmark by 2% pa or so over a 10 year period, and that investors needed to have a top quartile active fund manager to outperform an indexed fund.
Of course, in both instances, there is a case for the defence. In the FT piece, Aon point – no doubt correctly – to the importance of picking the right hedge funds and checking their capacity limits vis a vis their declared strategy; and our indexation study did find evidence of outperformance by active managers in small cap stocks.
But you have to wonder – is this a case where competition does not work effectively? There are a number of factors at work, including optimism bias and insider/outsider issues relating to asymmetries of information.
But ultimately you are reminded of James Tobin’s little old lady. You may recall the story – the little old lady has taken by an eminent economist to the floor of the New York stock exchange. The eminent economist explains that some people are selling shares, while others are buying them – at which the little old lady exclaims ‘but they can’t both be right!’
A very perceptive remark. The little old lady had correctly noticed that the trading in shares is close to a zero sum game – some people win and some people lose. If some fund managers are outperforming the benchmark, then by definition others will be underperforming it. In practice, of course, there are a whole variety of complications to take into account – the construction of the benchmark, role of new issues, and other factors. But the basic insight of treating the trading in shares as a zero sum game is a useful one that investors forget at their peril.

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