Hedge Funds and Mystique

One of the signs of a bull market is that hot money chases old ideas. Everyone wants to get into the most popular hedge fund, the one which is generating all the positive and glowing press about alpha generation. Popular hedge funds, though, have no reason to open the door to the masses (SEC prohibitions against doing the same notwithstanding), so so-called “funds of funds” popped up, promising retail and smaller investors a way to buy into these exclusive clubs. Fund-of-funds pool together your investment with hundreds or thousands of other random people, and invest that pool of money in James Chanos‘ latest fund. Suddenly, you are investing with the big boys.

Or are you?

Fund-of-funds’ promise has always been access to an exclusive club. But access comes at a price. Not only do you pay for Chanos’ management and his fee, you also pay for the fund-of-fund’s management and its fee. The New York Times reports:

Funds of hedge funds are rightly getting a dose of reality. Justifying their extra fees was always a tall order. Unremarkable returns and investor defections have made it harder. And the traditional fees — 1 percent of assets plus 10 percent of gains, known as 1-and-10, are fast becoming 1-and-zero.

Hedge funds’ frequently mediocre middlemen eked out an average return of just 13 percent last year — just half the rate for the average multistrategy hedge fund, according to Morningstar. The average fund of funds has performed less well than the average hedge fund in all but two of the last 20 years.

Also note that the Morningstar performance data cited above suffers from survivorship bias, and so cannot be relied upon as a measure of hedge fund managers’ talent. Most hedge funds fail, and most hedge fund managers never generate alpha over a sustained period. This is why the successful ones make billions of dollars for themselves and their investors.