From the April 2013 issue of Investment Advisor • Subscribe!

Debating Hedge Fund Myths: ‘The Most Expensive Bargain in Town?’

Alternatives come with some risk—but is it too much?

One of the most common complaints I hear about hedge funds and alternative investments is that their fees are too high. The typical 2-and-20 compensation model works well for managers, people say, but what about investors? It’s today’s equivalent of the old Wall Street punch line that used to be leveled against stock brokers: “Where are the customers’ yachts?” Another complaint I hear is that hedge funds and alternatives are too risky. Are hedge funds worth the price?

It’s a question that’s generating a lot of buzz lately. For starters, there’s the contest heating up between Warren Buffett and Protégé Partners, a fund of funds in New York. Ted Seides and his partners at Protégé are betting that a portfolio of five carefully selected funds of hedge funds can return more money to investors over 10 years than the S&P 500. Buffett has his money on the S&P 500. The contest is only half over—it began Jan. 1, 2008—and Buffett just took the lead for the first time. Thanks to the stock market rally in 2012, the S&P 500 index fund Buffett chose is up 8.69% over the last five years. Protégé’s picks are up just 0.13%. Several factors determine performance including the strategy and managers, but part of the reason for lagging the index is that hedge funds often underperform in bull markets, but shine in bear markets.

This is one of the points that Seides made in an essay he wrote as his contest reached its five-year mark. Appearing in the CFA Institute’s January 2013 blog and provocatively titled, “Hedge Funds: The Most Expensive Bargain in Town,” Seides demonstrated that long-term outperformance of hedge funds versus the S&P 500 is due to their outperformance in down markets. “Outperformance on the downside is far more important to long-term returns than outperformance on the upside,” he wrote, adding that the results are the same for almost every other 10-year period since 1994.

Seides is jumping into the fray created by Simon Lack’s book, “The Hedge Fund Mirage.” When it comes to opening sentences, Lack is right up there with Melville and Austen: “If all the money that’s ever been invested in hedge funds had been put in Treasury bills instead, the results would have been twice as good.” In response, the Alternative Investment Management Association (AIMA), the hedge fund industry association, responded with a 24-page paper saying Lack’s math is dead wrong.

Even if Lack’s assertion were true, he’s talking about all the money in all hedge funds. Hedge fund managers are like free-agent baseball players. All major league players are good athletes, but there are only a few Albert Pujolses or Derek Jeters. Likewise, superior fund managers are rare. I know how hard it is to find true talent: someone who can go long and short, whose performance doesn’t suffer when assets pass the $1 billion mark, and who can keep a steady hand on the tiller in rough seas. I agree completely with Lack’s warning that “the only way to successfully invest in hedge funds is to be above average at manager selection.”

Even though endowments and foundations have embraced hedge funds since the 1980s, it took the dot-com bust in 2001 and the 2008 financial crisis to make pension funds and public employee retirement systems discard hedge funds’ “wild west” image. Until then, the traditional thinking had been that investments that produce higher returns usually carry a higher level of risk. In the chart above, the gray bars represent down markets. As you can see, hedge funds and other alternatives, shown as green, dark blue, orange and red lines, had a different path during the tech wreck and the credit crisis. To paraphrase Seides, hedge funds and alternative investments can be the most expensive bargain in town.

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