Urban Legends Hedge Funds “deliver absolute returns in good times and bad”

It sounds good on paper, doesn’t it? Hedge funds are touted to be consistent performers, undisturbed by the ups and downs of markets. Why else would the wealthy give up a quarter of their profits in fees if not for the implicit guarantee of return in good and bad times? This (very) urban myth exploded in 2008/9 as markets melted down.

What is the kernel of truth to this untrue claim? It is the myth of arbitrage: the exploitable mispricing of an asset in two different marketplaces. For instance, if Stock A can be bought and sold for a penny more in New York than in Japan, they you buy a truckload of shares in Japan and simultaneously sell them in New York, earning a penny a share risk free. This particular fantasy ended with the Internet, when automated trading systems were programmed to take advantage of this situation. This insured that the opportunity, if it ever existed, quickly disappeared and has never been seen again. So the only risk-free returns from a hedge fund emanate from risk-free investments, like T-Bills (at least when they were AAA).

Since hedge funds do take risks, what is their utility? They claim to offer an improved risk-reward proposition as compared to, say, index funds, which offer market returns. More return for less risk sounds pretty good. Unfortunately, this hasn’t prevented dozens of hedge funds from going belly-up in the last three years. Even some prime brokerages have closed down their hedge fund operations.

Empirical studies show that many so-called market neutral strategies have had a decidedly long bias. A long bias is only good when markets are going up. Nonetheless, the allure of hedge funds to the wealthy remains. We believe part of it is pure snobbery – a hedge fund is an exclusive club and it costs millions to get in. Think Thurston Howell III from Gilligan’s Island. He and Lovey were the ultimate snobs, and we will bet he had his fortune sunk in one or more hedge funds. Or is that too an urban myth?

In any event, hedge fund investing is bound to stick around for the foreseeable future. People love the idea of low risk coupled with high return, and will delude themselves into ignoring all empirical knowledge that says markets are random and efficient. Ponzi schemers are delighted by this human trait, and will continue to ply their wares alongside legitimate hedge funds. Our advice is to stick to a low cost index fund and dollar cost average your way to wealth and fame. Or at least to a decent nest-egg.