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The Reformed Broker

Why hedge funds are a joke

2011 should have been the perfect year for hedge funds to thrive. What happened?

By Joshua M. BrownGuest blogger / February 21, 2012

A grounds keeper trims the hedges in Taipei, Taiwan, Wednesday, July 7, 2010. Brown argues that hedge funds should have been able to thrive in a volatile year like 2011, and the fact that they didn't shows that they are no longer effective.

Wally Santana/AP/File

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I think the performance of so-called hedge funds as a group wouldn't be so roundly mocked and scrutinized if:

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Joshua has been managing money for high net worth clients, charitable foundations, corporations and retirement plans for more than a decade.

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a) there weren't so many of them and...

b) their compensation wasn't so incredibly disconnected from what they've been able to deliver and...

c) they actually lived up to their nomenclature and actually hedged

But there are like 8000 of them and they charge more than double what traditional asset managers are able to and not only do they not hedge - it turns out that a great many hedge funds are really leveraged, highly concentrated vehicles that put on big positions and lever up to magnify them in the quest for a grand slam.  There's nothing wrong with a fund's portfolio being constructed that way if that is the manager's strategy - but let's please stop referring to that as "hedge funds" lest Alfred Winslow Jones continue rolling in his grave until he bores his way to China.

Here's a stat you may not have seen in your post-holiday comings and goings, but it is one that should never be forgotten...

From FT Alphaville:

Many hedge funds are well below their high watermarks, meaning that they can only charge investors management fees, which at around two per cent is only enough cookie money for a year or two unless one is a ginormous fund. According to Credit Suisse data cited by the Economist, 67 per cent of hedge funds were below their watermarks at the end of 2011.

While returning cash in the face of adverse markets may be the noble thing to do, there is also the risk "that high-water marks could skew funds’ investing decisions. Managers who have not earned a performance fee in years could take bolder bets to get back into the black."

Indeed, the FT pointed out in January (using the same Credit Suisse dataset) that leverage has crept up ever so slightly to 2.5 times, off the post-crisis low of 2.4.

To recap, years like 2011 are the exception not the rule - high volatility and a year of massive swings is an almost impossible climate for a traditional asset manager to navigate more than in a middling fashion.  Guys like me with clients planning for retirement are tasked with a mission of getting out alive and in one piece.  But hedge funds were supposed to have been able to thrive in a year like 2011.  That is how they typically present themselves and the exploitation of volatility along with non-correlated returns is the assumption for most hedge fund investors.

When looked at in this context, it is impossible to escape the conclusion that hedge funds as an asset class have just failed their final exam.

Here at TRB we root for everybody to find their way into successful investments and investment vehicles, no hating is the primary rule.  But I mean, come on!

The Christian Science Monitor has assembled a diverse group of the best economy-related bloggers out there. Our guest bloggers are not employed or directed by the Monitor and the views expressed are the bloggers' own, as is responsibility for the content of their blogs. To contact us about a blogger, click here.To add or view a comment on a guest blog, please go to the blogger's own site by clicking on www.thereformedbroker.com.

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