Veritas – Why investors may question if hedge funds are worth the money this year

When Alfred Winslow Jones established the first hedge fund in 1949, its fee structure raised eyebrows, notably the fact Jones kept one fifth of his fund’s profits for himself.

Twenty years later, after Jones had made about 5,000% by 1968, investors didn’t care.

Jones had made 100 percentage points more between 1960 and 1965 than the 225% over the same period from the best mutual fund.

Investors certainly got what they had paid for.

These days investors still pay hedge managers handsomely – though ‘2 and 20′ is now ‘1.6 and 18.3′, says Eurekahedge – but they may be questioning if their chosen manager is really worth the money.

Hedge funds may aim for absolute returns, but investors will always take fees into account, too, and compare hedge funds with active and passive mutual funds.

They give managers assets to make gains and limit losses using various sources of ‘alpha’, most notably stock picking, and investors rightly expect hedge managers to be better at it than mutual fund managers.

Based on research Goldman Sachs released last week after looking at hedge funds’ largest long equity positions, it could be argued the average equity hedge manager has not been worth the money, this year at least.

For starters, only one in 10 (11%) funds was beating the S&P 500 index of US shares so far this year.

Concerning for the industry were shortcomings in managers’ stock picking ability.

The 50 stocks that appeared most often in managers’ reported top 10 long positions for mid-year – in 13F filings with the SEC – had underperformed the S&P 500 by mid-August, making 12.4% versus 13.3%.

(The list, compiled by Goldman Sachs, was not exactly managers’ ‘favourite’ stocks – that would require analysing overweight positions – but it is fair to say the 50 shares were those that fundamental managers are relying on most heavily in order to perform.)

The positions had underperformed the index, and also probably US tracker funds and ETFs, even after deducting fund fees.

Perhaps even more concerning for managers and investors was the fact that, by early August, the 50 top hedge fund shares, with 9.2% returns, were also failing to beat the average actively managed long-only fund, which made 9.9%.

And active mutual funds do not, with few exceptions, charge the eyebrow-raising 20% of fresh profits.

Hedge managers are on average just 43% net long, suggesting they do not expect a US market rally to bolster their returns soon.

To satisfy investors, therefore, they will have to improve picking of their positions, both long and short – even if this does not make them 5,000% over the coming decade.

Perhaps investors can draw some hope from the longer term performance of managers’ largest 10 equity holdings. They have beaten the S&P 500 by 0.54% per quarter since 2001, with a Sharpe ratio of 0.21, Goldman Sachs’ examination found.

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