Do Hedge Funds Soak the Rich?

Written by Monty Agarwal, MA Capital Management

I recently read an article titled, “Who is running these hedge funds – communists?” by Brett Arends that talked about the disservice being done to the top 1% by the hedge funds in terms of high fees and poor performance. The article further went on to compare hedge funds to communists. I believe that the article is extremely misleading and there are quite a few naïve suggestions and comments in the article that need to be addressed in the interest of investor “hedgucation”.

The author refers to the hedge fund industry as a communist conspiracy attacking the rich by transferring wealth from the rich to the hedge fund managers. Perhaps the author should check the definition of “communism”. There is no one forcibly taxing the rich and transferring wealth through surreptitious taxation or at the point of a gun. In fact, hedge funds are the paragon of capitalism. Wealthy investors, who are usually ultra-high net worth clients or sophisticated investors like pension funds and endowments willingly approach hedge funds, conduct due diligence, negotiate fees and other terms and then make an investment which they can redeem as per the terms negotiated. With over 5,000 active hedge fund managers in the world vying for capital, investors have their choice and the power to negotiate terms and conditions. I am not sure how this process could be anymore transparent or just. So to compare the hedge fund industry to communist policies in North Korea and Russia, as the author of the article does, is nothing more than cheap sensationalism.

The fact that these hedge fund traders wear Breitling watches, use iPhones or Bloomberg terminals for data feeds does not make them evil. After all in a free capitalist society, like we have in the US, a person is free to spend their money as they please. The author also insinuates that an education from Harvard or MIT is unnecessary in the financial world. I thought that working hard and striving to better oneself at some of the most prestigious schools in the country was a good thing. But, maybe that is somehow a communist thing in the author’s world. One of the most successful hedge fund managers, Jim Simons of Renaissance Technologies is a Ph.D. and actively seeks out Ph.Ds. for his fund. And by the way he has produced returns for his investors for decades that have trounced any mutual fund, S&P 500 and even Warren Buffet. Jim is not the exception, in fact systematic investing which utilizes sophisticated computer algorithms designed by Ph.Ds. is the future of investing.

After denigrating the hedge fund industry, the author of the article, Brett, suggests that the top 1% buy the Vanguard Total World Stock Index ETF (VT), because it has low fees and has beaten every single hedge fund index in 2013. We do not judge an investment by its one year performance or just by its level of fees. That would be highly naïve. Let us look at the risk and performance analysis of the ETF (VT) since inception.

Vanguard Total World Stock Index ETF (VT), July 8, 2008 – Dec 31, 2013

Source: MA Capital Management, Yahoo Finance

The performance of the VT fund was not that hot in 2008 or 2011. In fact, given human psychology, most investors would have dumped the fund at the end of 2008 and missed the returns of 2009. It is a mistake to assume that an investment’s returns are the same as an investor’s returns. Most investors are driven by greed and fear and tend to buy investments after they have had a long run up and are therefore expensive and sell them after they have lost money and are cheap.

Most well healed investors, i.e. the 1%, want absolute return investments, i.e. investments that make money consistently regardless of the performance of any index. So to compare a volatile long-only investment like VT with a well-constructed portfolio of hedge fund investments is like comparing apples to oranges. Investments in the 1% world are judged by their risk adjusted returns and not just the returns of the past year. That’s an important lesson that, in my opinion, should be learned by the other 99% as well.

We are in the business of providing alternative investments to the high net worth community and therefore conduct extensive due diligence to meet our fiduciary responsibilities. One aspect of this responsibility is to structure fees that are representative of the alpha in the investment portfolio and not beta. The traditional 2% management fees and 20% performance fees are not the norm in the hedge fund world these days. Most management fees are in the 1% range and the performance is tied to alpha, through hurdle rates, high water marks and claw-backs. This change in the hedge fund fees came about through increased competition and investor feedback. Hardly a trait of communism, wouldn’t you say?

Constructing a robust alpha generation portfolio is a scientific process that needs to be monitored and adjusted frequently. If done right it can generate risk adjusted returns that far exceed the returns of the S&P 500 or VT or any other index. Proof is always in the pudding. The flow of assets into hedge funds has been climbing steadily since 1980, not declining. Traditional mutual funds that have for years offered long only investments are rushing to introduce hedge funds in the form of mutual funds. If the hedge funds were indeed soaking the rich and were a communist plot to rob the rich, I do not believe that the trend would be spreading as it has.

The following chart shows the flow of assets into the hedge fund industry but does not include the assets in the alternatives mutual fund industry.

Source: BarclayHedge

And finally in the interest of full disclosure, I am a hedge fund manager,I do wear a Breitling but do not throw my iPhone at the wall and am definitely not a communist!

Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by MA Capital Management, LLC unless a client service agreement is in place.

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