By Jason Zweig | 7:47 pm ET July 25, 2013
Image Credit: Christophe Vorlet
In Thursday’s indictment of SAC Capital Advisors on insider-trading charges, there is plenty of blame to go around.
The giant hedge-fund manager and its founder, Steven A. Cohen, deny wrongdoing, and Mr. Cohen wasn’t criminally charged; a spokesman for SAC didn’t respond to a request for comment.
But outlandish fee and compensation structures, along with pressure from clients to beat the market at all costs, make it surprising that hedge funds don’t always go right up to the line and sometimes over.
All hedge funds, including SAC, traffic in perfectly legal inside information: the exclusive knowledge of how skillful the managers are. That sort of inside information is much more problematic than trades that might have broken the rules. When you buy a hedge fund, you take the other side of the trade from people who know vastly more than you about the only thing you are buying: their abilities.
To make it a fair fight isn’t easy, since hedge funds don’t disclose their entire portfolios daily as exchange-traded funds do or quarterly as mutual-fund managers do. “The industry is far more transparent than it used to be,” says Nicholas De Monico, chief of the hedge-fund strategies group at Commonfund in Wilton, Conn., which has $2.2 billion invested across more than 50 hedge funds. “But getting the data, interpreting it, making sure it’s correct—that demands a lot of hard work, and there’s no glamour to it.”
Some purportedly sophisticated investors don’t seem to understand this. “Your average large, multistrategy hedge fund can have thousands of positions,” says Ted Seides, president of Protégé Partners, which manages a $2 billion portfolio of hedge funds. “It’s more than a full-time job just to interpret the positions of one fund like that, let alone a portfolio of 20 of them.”
Yet some big investors seem to buy hedge funds much the way the rest of us pick hotel rooms or buy breakfast cereal.
According to a global survey by Deutsche Bank in December, a third of big investors don’t require hedge funds to have a track record before investing in them. Three-quarters of pension funds—and half of insurers and endowments—hire outside consultants to conduct due diligence on their hedge funds instead of doing it themselves. Some pension funds, I am told, even decline to review the exact holdings in their hedge funds because they don’t want to be held accountable for the quality of their analyses.
What makes big investors so willing to close one or two eyes—and pay through the nose for the privilege—is the pipe dream of safety and outperformance.
Everyone wants double-digit returns in a world of paltry bond yields. Trillions of dollars are chasing the few managers who can earn high returns on a few billion dollars apiece. Clients pay on average up to 2% of assets and 20% of profits—and occasionally as much as 3% and 50%, as the government alleges at SAC.
“You should pay hedge-fund managers all that extra money so they don’t lose you a lot of your capital in bad markets,” says Elizabeth Hilpman, chief investment officer at Barlow Partners, which invests exclusively in hedge funds. “But many institutional investors want it all: They want the downside protection and the huge outperformance.”
Big institutions are among the most desperate performance-chasers on the planet. “The consultants tell them they can get 8% [annual returns] by playing the same game that’s being played by everyone else, if they just play it better,” says Keith Ambachtsheer, an expert on pension strategy at KPA Advisory Services in Toronto. “But the math doesn’t work.”
Many hedge-fund managers, such as Seth Klarman of the Baupost Group, James Simons of Renaissance Technologies and George Soros of the Quantum Fund, have made their clients rich. But only one in 10 institutions reported earning at least 10% on hedge funds in 2012, according to the Deutsche Bank survey. Still, a third expect their hedge funds to return at least 10% this year.
So far at least, that doesn’t look likely. The HFRI Fund Weighted Composite, an index of hedge-fund performance, gained 3.55% in the first half of this year; it was up 6.36% for all of 2012.
Despite their recent lame returns, most hedge funds still charge the same high fees. As the great economist Tibor Scitovsky explained decades ago, when sellers of a complex product or service are the only ones who fully understand what they are selling, buyers can’t objectively distinguish quality. The result: an automatic oligopoly in which sellers compete on the appearance, not the reality, of high quality.
Perhaps we should be indicting — not criminally, but intellectually — an entire ecosystem. Yes, plenty of hedge funds are guilty of exploiting their clients with lavish fees for flaccid performance; some might even be breaking the law. But their clients are far from blameless: “Sophisticated” institutional investors still insist on believing in a Tooth Fairy that can somehow miraculously provide market-beating returns for everyone. Maybe that is the biggest crime of all.
Source: The Wall Street Journal