Skip to content

HEDGE FUNDS, CARRIED INTEREST ETC. (PART III)

May 18, 2016

HEDGE FUNDS, CARRIED INTEREST ETC.  (PART III)

With one in five university endowment dollars and billions in retirement funds in the clutches of hedge funds, it must be because hedge funds make better investments on behalf of their clients that consistently outperform the market, right? I mean, there must be a rationale for investing your money with hedge funds considering that you are paying them 2 per cent per year of all the funds you have with them irrespective of performance plus a contingent agreement that they will collect 20 per cent of any investment profits you make for the year, if any. That is a hefty commission to be paying a hedge fund operator, who has nothing at risk other than overhead, far higher than commissions you would be paying some mutual fund operator or indexer, but the hedge fund outperforms the market and this is a justification to invest in hedge funds rather than the market, right? Read on.

Dayen noted that “Hedge fund managers traffic in myths, all of which fall apart on close examination. The first myth is that they make markets more efficient by betting against unsustainable or anomalous trends. A related claim is that they play a kind of regulatory function by policing markets by putting salutary pressure on corporate executives. For the most part this is nonsense.”

In the movie I saw (The Big Short) which helped precipitate this essay, the hedge fund protagonists made a lot of money by seeing before others did that the housing market was pumped up by subprime loans and was a bubble that would soon burst. Loans were made by Countrywide and others to people who could not pay them given their credit history, and the bonds put together by the big banks which assumed that such loans would be repaid with minimum instances of default were in fact junk bonds sold as Triple A-rated paper – by rating agencies PAID BY THE BANKS. Fraud, anybody? The big banks did pay billions of dollars after the crash for mortgage fraud (after millions of foreclosures and after the immense and continuing damage to the larger economy was assured). The hedge fund operators in the movie, sensing the bubble was about to burst, shorted the bonds and made a bundle. Did that make markets more efficient as claimed by the crap-shooting hedge fund operators? Of course not! All it did was make a few people rich while the foreclosed millions and their families sought a spot under the bridge.

Dayen also notes that “Hedge fund managers also argue that they earn super-normal returns through superior knowledge of the global economy, creating the ‘secret sauce’ that allows them to outpace the market; that in addition to deciding which companies will succeed or fail, they discover market inefficiencies and identify global trends. They use this knowledge to bet on changes in sovereign bonds, spreads on a country’s bonds, or commodity prices like oil. If they see trouble ahead for Asia, they’ll short anything with export to Asian countries, and if they think the EU will take off, they’ll make moves there.”

There have, of course, been instances where hedge fund managers have made tremendous returns on their clients’ investments, enough (with the complicity of the business press) to propagate the continuing myth that hedge funds outperform the market. George Soros, for example, once decided that the British pound currency was overvalued and proceeded to make over a billion dollars by crashing the pound, thus demonstrating that hedge fund operators with their huge pools of capital can affect not only corporations they may be shorting but can take positions that adversely affect national economies as well, which further demonstrates a need for heightened regulation such as that of their competitors, mutual funds, must live with day to day. The 1940 Act (as amended) that allows hedge funds an escape from the New Deal regulations should be amended to include hedge funds under the same regulatory regimen and SEC oversight as that applied to mutual funds. That, along with amendments to the internal revenue code doing away with “carried interest,” would go far to even up the playing field between competitors and reduce the risk to our economy as well.  Left to my own (Trump-like dictatorial) devices, I would not do away with hedge funds altogether; rather I would corral this wild bull in our economy via rules and regulations that look primarily to the interests of all the people rather than to enrichment of a few people.

So, to the point, do hedge funds beat the market? Per Dayen: “But here is the most revealing false claim of all. Despite all these methods, and despite all the money pouring into the industry, the stark truth about hedge funds is this: On average, most of them don’t beat the market.” Of course, hedge funds that close (and many did during the recession) don’t report results and since reporting is voluntary, underperformers could simply opt to hide their losses as well, thus skewing the statistics in favor of winners, who would be more anxious to broadcast their results, but estimates provided by LCH Investments for last year are that the top 20 hedge funds – out of 11,000 – made $15 billion and the rest of the industry LOST $99 billion. That’s a net loss of $84 billion for the industry last year, and LCH says the results so far this year are worse.

Dayen further notes that “If you go outside the top 20 super-managers, you find that hedge funds UNDERPERFORM the S&P 500, index funds with a diversified mix of companies, balanced mutual funds, and,” (get this!) “according to a Cambridge University study, a collection of stocks picked at random by monkeys!” Other estimates are that in 2014 hedge funds overall returned 3 per cent; the S&P returned 11 per cent, and the spread was even worse in 2013. Let’s hear it for monkey managers of hedge funds!

Hedge funds have lagged the S&P and other benchmark portfolios since the early 2000s. Many hedge funds went out of business during Bush’s Great Recession, which tells us much about their exposure to risk. So in view of such subpar performance, why do investors and institutions around the world continue to pay higher fees for lower performance, making a handful of managers notoriously rich, asks Dayen? Currently historic lows for interest are one explanation. Others include investor inertia, and even sophisticated investors can be seduced by the big returns made by the very top producers in the industry.

It would seem that the logic for investing in hedge funds is that they beat the market. If they do not, but only match the market’s performance or, as we have seen, don’t even do that, especially with their high commissions charged, then one wonders why investors stay with such losers. The good news is that some of them, recognizing their fiduciary duties to their retired and to be retired teachers, firemen and policemen, are moving on. The California Employees’ Retirement System, the nation’s largest, pulled out of hedge funds in September 2014, followed by a Dutch health-care workers’ fund in 2015, so one can hope the exodus is beginning in this crapshoot where investors never see the dice.

The industry started by Jones is an accident of history, a gift to rich families, but it has morphed into a financial monster that can not only wipe out its investors but damage national economies as well. With its trillions to invest, it represents a risk to our economy that we need not tolerate. Dodd-Frank required hedge funds to give their name, rank and serial number to the SEC but did little else. The industry should be placed back under the 1940 Act which would mandate disclosure, alter fee structures, and eliminate the use of leverage (bank loans which further magnify risk).

Some say that if we do that we will put hedge funds out of business. I can live with that since their existence is both a threat to and a drag on our economy.    GERALD     E

 

 

Advertisements

From → Uncategorized

Leave a Comment

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: