I generally like to think Adam Smith was right.

The market, whether it’s for socks or stocks does a pretty good job on its own.

The funds, companies or industries that provide no value usually end up having a short life.

However, this isn’t necessarily true in all cases.

Take hedge funds. What value do they offer?

Well, the good ones put more money in your back pocket. But these ‘good ones’ are becoming few and far between.

Take a look at how the average return for the industry is declining.

hedge fund industry performance

Source: Financial Times

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And these are just the ones publishing their performance.

You’d imagine the really terrible ones wouldn’t want anyone to know their returns, and thus refrain from making their performance public.

Thankfully, the really terrible ones do end up closing. In fact, in the last few years the number of exiting hedge funds grew much faster than new entries.

So maybe Adam Smith’s invisible hand (which guides the market to equilibrium) isn’t dead just yet.

But if investors are seeing returns turn from good to subpar, why the hell do they keep giving hedge funds money?

The amount of money hedge funds control exceeds US$300 billion. In 2012, this figure was closer to US$39 billion.

A real question has to be asked. Do we even need hedge funds?


Do we really need hedge funds?

I think The Independent explained the general view of hedge funds well when they wrote:

Hedge funds are “locusts”, speculating against decent companies and entire countries until they collapse into bankruptcy.

And what’s worse, most are rewarded regardless of their performance. From Vice (my emphasis):

Some Americans seem to dislike financial professionals because they appear to get filthy rich performing nebulous alchemy that serves to make rich people richer. When it comes to hedge funds, that first part is beyond dispute: According to an annual ranking released on Tuesday, the top ten hedge fund managers in the world took home more than $10 billion last year.

But the crazy part is that five of the top 25 earners in the field actually lost their investors’ money. That revelation comes amid a growing effort by activists to get public pensions to ditch hedge funds, which typically charge exorbitant fees and often deliver returns that aren’t any better than sticking money in an index fund and forgetting about it.

And that’s likely the biggest problem people have with hedge funds, myself included. They get paid ridiculous sums, just for breathing.

For example, consider a hedge fund that has US$3 billion of client money. Now imagine the hedge fund manager makes some bad bets and loses money.

By the end of the year the fund now manages about US$2.5 billion of their clients’ money.

And even though managers lost 16.7% for investors, the fund still charges 2% on assets at year’s end.

That means investors didn’t just lose 16.7% of their capital. The fund is also charging them another US$50 million for their services…

You can see how easy it could be to vilify such an operation.

But even still, I believe the market needs hedge funds…the good ones at least.

Let me explain why. [openx slug=inpost]


What advantage does a hedge fund have?

The mainstream media doesn’t always trash hedge funds. In 2008, when a select few hedge funds performed far better than other assets in general, the media portrayed managers as geniuses.

Bloomberg Businessweek writes:

In the spring of 2008, hedge fund manager David Einhorn gave the most memorable speech of his career. At a conference in Manhattan, he took to the stage at the standing-room-only concert hall and delivered a scathing attack on Lehman Brothers.

Lehman filed for bankruptcy four months later.

Around the same time, another New York hedge fund manager, John Paulson, was minting a fortune by betting against U.S, subprime mortgages. And in London, a firm run by lower-profile manager, Alan Howard, had prepared for a financial crisis by cutting risk and buying investment contracts that would profit from market volatility.

‘…Einhorn, Paulson and Howard were part of a small cohort who showed foresight at a time when others were racing towards a cliff.

The article goes on to show the now lagging performance of the above managers, insinuating that these one trick ponies got their fame from the 2008 crisis.

So why am I saying we need hedge funds?

It’s because they provide a very important service (the good ones do at least).

They can aggressively short stocks. This is when you borrow stock you don’t own and sell it to another investor.

To close out your position you’ve got to buy back the stock, returning it to the lender.

The idea is that you want to sell the stock when it’s trading for far more than it’s worth and buy it back for cents on the dollar.

It’s a risky trade. The market can always rise higher. But because of very little regulation, hedge funds can pursue this strategy aggressively.

So why is this important?

The best shorts are those stocks which trade for far more than they’re worth, but also happen to be frauds and/or Ponzi schemes.

These are the kind of shorts that the really good hedge funds go after.

Most investors simply don’t have the time or interest to weed out these frauds. And it’s those investors who buy them that end up losing everything.

To prevent this needless waste of wealth, good hedge funds can step in and provide this invaluable service.

They can publicly criticize management, short the stock and rid society of companies like Enron and WorldCom.

OK, so how can we get a hedge fund industry full of the good ones?


The outcome…

The problem with the hedge fund industry isn’t the greedy managers. People will always be greedy.

The problem is those people pouring money into the industry, entities like sovereign wealth funds and alike.

Many of these funds care little about maximising returns. Most are far more interested in matching returns to future capital needs.

And for most funds that means diversification.

They spend a little here, a little there and boom they’ve created a diversified portfolio that still does OK when the market panics.

Until the ‘big money’ starts to invest as if they were investing their own money, I find it hard to see how we could clean-up in the hedge fund industry.

Billions will continue pouring into the industry, attracting not just the bright and conscientious, but the savvy, dubious managers as well.

Your friend,

Harje Ronngard