(MoneyWatch) As we jump into this quarter's hedge fund update, I wanted to note an excellent book by Simon Lack called "The Hedge Fund Mirage." Lack, who spent 23 years with JPMorgan Chase (JPM), chronicles the history of the hedge fund, highlighting the many subtle and not-so-subtle ways that returns and risks are biased in favor of the fund manager.
One of the shocking things Lack uncovered is that the hedge fund industry as a whole took 84 percent of the $49 billion of generated total profits (measured by the returns provided by hedge funds above the return of one-month Treasury bills).
While that's an astonishing figure, it might be worth it if investors experienced enough outperformance. Unfortunately, we've repeatedly seen that hedge funds lag many common assets, and this year has been no exception.
The table below presents the returns of the HFRX Global Hedge Fund Index and compares it to the performance of various stock and bond indexes, both for the period 2003-2011, and also for the first half of 2012.
Hedge funds underperformed every stock asset class over the prior nine years and even managed to underperform the three bond indexes, while taking far more risk. In the first half of 2012, they also underperformed every stock asset class.
This mirrors what Lack found in his research as well. He examined the period 1998-2010 and found that the HFRX Index actually produced fairly good results early on. However, it seems that investors were late to the party. Over this period, the HFRX Index earned 7.2 percent, while investors earned 2.1 percent. This resulted from the fact that there were fewer dollars invested when industry returns were high and more dollars when they were low.
Lack's analysis showed that in 2008 alone, the hedge fund industry lost more money than all the profits it had generated during the prior 10 years!
Given the evidence, the only logical explanations I can think of for the continued popularity of hedge funds are that either investors are unaware of the data or that individuals invest in hedge funds for the same reasons they buy Rolex watches or Gucci bags -- they're expressions of status, prestige, exclusivity, and sophistication. Letting emotions such as these determine investment decisions is a recipe for disaster.
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