Is the "Smart Money" Really in Hedge Funds?

For almost two decades, hedge funds ruled the roost, providing what wealthy investors saw as a premier ticket to big returns. Assets mushroomed from about $38 billion in 1990 to $2.48 trillion at their peak in 2007. Demand was incredibly high during the 2002-07 bull market. Brokers and other salespeople sold hedge funds of funds (that is, funds that invested in other hedge funds) to the unwary with an extra layer of fees.

Then came the market meltdown, which spared no one, including hedge funds. And now that the dust is settling, a new study finds that the performance of hedge funds -- the most exclusive money on Wall Street -- has been downright meager. A forthcoming paper in the Journal of Financial Economics found that from 1980 through 2008, the average hedge fund returned an annualized 6.1% after fees.

How bad is that? By contrast, Standard & Poor’s 500-stock index returned an annualized 10.8% over that same stretch. If you had simply invested your money in three-month Treasury bills, you would have earned 6.2% annualized.

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But that’s not the worst of it. Coauthors Ilia Dichev of Emory University and Gwen Yu of Harvard not only looked at raw returns for hedge funds but also determined how much the average dollar invested in hedge funds actually returned.

Take a fund that returns 10% in year one, then loses 5% the following year. The fund’s reported, or time-weighted, return would be 4.5%.

But if you really want to know how much investors earn you must look at dollar-weighted returns, which adjust for the amount of assets in a fund over time. Using the above example, suppose the fund had $1 million in assets during the first year. Then investors, impressed with the first year’s performance, send more money to the fund and assets average $2 million during the second year. In this case, the dollar-weighted return -- the return on the average buck -- would be a big, fat goose egg. “Dollar-weighted returns reflect the actual experience of real-life investors,” the professors write.

How did the average hedge-fund dollar do? It earned 2.9%, the study found -- less than half the reported return of the hedge funds themselves.

Reason: Investors flooded into hedge funds after they had done well. “We found massive returns-chasing,” says Dichev. “There is return-chasing in mutual funds, but in hedge funds it’s much more pronounced.” (A Morningstar study cited in the paper found that dollar-weighted returns for stock mutual funds trailed the funds’ reported returns by an average of 1.5 percentage points per year.)

Not just anyone can invest in hedge funds -- you must have investable assets of at least $1 million. Those who do qualify are hit with onerous fees. Hedge funds charge from 1% to 2% of assets under management per year. Plus, they claim 15% to 20% of annual returns. Never was there a more lucrative license to print money -- for those who run the funds.

Because hedge funds are secretive, Dichev and Yu were unable to obtain returns for all funds, much less the flows of cash in and out of them. Despite using two databases, Dichev estimates that they captured only about 70% to 80% of the existing data. Still, they analyzed almost 11,000 hedge funds.

Could the professors have missed out on the better hedge funds? Don’t bet on it. Hedge funds, in general, report results only when they want to. With regard to the data he and his colleague examined, Dichev says, better-returning hedge funds are much more likely to have reported results. “If anything, these data paint a somewhat optimistic case,” he says.

Hedge funds are often “incubated” with a small amount of the managers’ money. Only the better- performing ones ever become available to investors. And once they go public, they often report the returns they generated while in their incubation stage.

Of course, not all hedge funds are lousy. Far from it. Otherwise, you wouldn’t read about people such as George Soros and John Paulson. But the paper shows that average results are terrible.

The bottom line: The “smart money,” which flocked to hedge funds, did much more poorly than investors who bought ordinary mutual funds.

Steven T. Goldberg (bio) is an investment adviser.