In fact, the average
returns over the past 20 years for the industry — the returns actually
experienced by the vast majority of hedge fund investors — are less than they
would have earned in government bonds. (And this isn’t just a matter of the
huge losses in 2008-2009, though obviously that didn’t help.) This isn’t
to say that some customers aren’t lucky in their choice of funds, but the odds
are stacked heavily against them.
As if this isn’t bad enough, fraud in the hedge fund industry is hardly confined to Bernie Madoff. The unregulated and opaque nature of the funds lends itself to fraud. Plenty of managers have succumbed to the obvious moral hazard, and Simon Lack, in his book, “Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to Be True“, provides plenty of examples. With a hedge fund, the entire investment is at risk, so fraud is an ever-present concern.
The Hedge Fund Fraud Casebook provides over 100
examples of hedge fund fraud, all of which happened before anyone realized that
Bernie Madoff, the former president of the NASDAQ and famous fund manager, was
running a giant Ponzi scheme, but also before the frauds of Conrad Seghers,
James Dickey, Ed Strafaci, Mark Focht, Paul Eustace, Michael Berger, and many
more were uncovered.
When the industry standard is to charge high fees and to tell your customers what you want and when you want, can any of this be a surprise?
When the industry standard is to charge high fees and to tell your customers what you want and when you want, can any of this be a surprise?
Surveying the industry
landscape at the end of his book, Lack says he used to blame the managers for
running a rigged game, but eventually he turned around and now blames the
customers for enabling this bad behavior. This is a funny kind of Wall Street
blame-the-victim ethics, but it is true that a lot of institutional investors —
like pension funds — have the resources to have discovered these facts on their
own. And they haven’t.
Let’s be clear: any
investment portfolio should be hedged somehow. Even within the world of stocks,
most fools know you don’t make a portfolio out of a single company’s stock.
Diversifying stocks is
one way to hedge. Diversifying investments so that you’ve got some money in
things that tend to go up in value when your other investments go down is also wise.
This is what hedge funds originally did.
But the evidence
implies that the lowest cost way to do that now might be to do it yourself.
Want to hedge your exposure to stocks with investments in bonds? Go find
a friendly bond dealer and buy some. Or invest in a mutual fund for bonds. Want
to invest in failing mortgages? You can find ways to do that without
paying 2-and-20. Gold? That can be done, too, if you must.
But if you go to a
hedge fund, you should know that you’re walking into a casino where the odds
are great that you’re not going to walk out with nearly as much money as the
advertising claims. If you walk out with any at all. The occasional lucky patsy
can walk out of a rigged game a winner, but that doesn’t mean the game isn’t
rigged. As they say in poker, if you can’t tell who’s the patsy at the table,
well, you’re the patsy.
If you’re not an
“accredited” investor, who can afford to dine at tables like these, why should
you care? Because, though you might not be one yourself, you probably belong
to one. Institutional investors — pension funds, university endowments, banks,
charitable foundations — make up a huge proportion of the money invested in the
hedge fund industry, though exact data is hard to come by.
You probably have a
piece of this somewhere, perhaps as a taxpayer whose municipal or state
government is investing heavily in hedge funds, or as an alumnus/a of some
college, or as a customer at a big bank. Rhode Island’s pension fund has
increased its investment in hedge funds substantially, and as much as a quarter
of the value of the fund is now invested there.
The stated reason
behind this is to increase the returns. This is important, as a result of the
2011 pension changes. With fewer people paying less money into the pension
fund, investment returns are more important than ever before to make good the
state’s debts to its retirees. Perhaps it’s possible to negotiate lower fees,
or find ways to increase the transparency of the funds you invest in, but there
are valid reasons to be very skeptical.
Here and in other
states, when your money winds up in a hedge fund, the people in charge of your
money have put it in the care of fund managers whose incentives do not involve
keeping your best interests at heart.
And while those Very
Serious People invest your money in these risky and opaque funds, they are
relying on the empty promises of representatives of a corrupt industry. If they
do well, you’re lucky. If, as is more likely the case, they do not — well,
you’re the patsy.
Click here for Part I of this series
Tom Sgouros
is a freelance engineer, policy
analyst, and writer. Reach him atripr@whatcheer.net. Buy his book,
"Ten Things You Don't Know About Rhode Island" at whatcheer.net
