In Lesson 4-4 we discussed hedge funds and private equity – two of the major alternative investments. We’ll focus in this entry on hedge funds which have the reputation of being the ‘rock stars’ of the investment world. The conventional wisdom is that the smartest people work for hedge funds and that they generate the best long-run performance.
For the 19 years from 1990 to 2008, hedge fund returns beat or tied the S&P 500 15 times – according to Hedge Fund Research (HFR), which analyzes the performance of the hedge fund industry. Unfortunately, 2013 could be the fifth year in a row that hedge funds, on average, underperform the Standard & Poor’s 500 stock index.
Not only has hedge fund performance been spotty since the 2008 financial crisis, but the industry has a bruised image. In this 2009, Raj Rajaratnam, the billionaire founder of the Galleon Group, a New York based hedge fund, was convicted of trading on inside information and is presently serving an 11-year prison sentence. Additionally, Steven Cohen’s SAC Capital Advisors is the latest hedge fund to be accused of insider trading and making hundreds of millions of dollars illegally. Additionally, Phil Falcone is accused by the Securities & Exchange Commission of using funds from Harbinger Capital to pay his taxes.
Investment masterminds, like John Paulson of Paulson & Co. and Ken Griffin of Citadel, have suffered significant losses the past several years. And in the first half of 2013, hedge funds returned an average of nearly 4%, compared with almost 13% for the S&P 500, according to HFR.
Interestingly, assets under management by hedge funds are at a record level and performance could turn around. However, there is now some pricing pressure on the 2/20 fees that hedge funds charge. (Most hedge funds have an annual management fee equal to 2% of the assets under management, plus 20% of any profits). Because of the management fee, hedge funds make money even when its investors lose. It will be interesting to see if sub-par performance continues, how long before hedge funds are required to lower their fee structure.