Sunday 11 December 2011

Sunday, December 11, 2011 Posted by Jake 2 comments Labels: , , ,
Posted by Jake on Sunday, December 11, 2011 with 2 comments | Labels: , , ,

As we pointed out in an earlier post, the maths shows that overall bankers' performance is no better than a monkey can do picking stocks at random - effectively like an index tracker. 

An academic study has found that Hedge Funds, who justify massive remuneration to their staff by their superior performance, actually perform only a teensy bit better than the market average. The industry gets away with this fib simply by not including their bad performances in their figures.

If premier league football clubs could rank themselves this way, they would all be champions with 100% wins - because they would not report the times they lost or drew.

Alpha is the posh term for the profit an actively managed fund earns over the index linked market average. Hedge Fund managers justify their vast remuneration by claiming consistent average returns of 3%-5% above the market. And they have managed to fool academics, regulators, and most importantly investors for years. The study shows that average returns are closer to 0.05% per quarter above the market.

Extracts from report:

  • [Hedge funds manage] over $1.97 trillion in assets and accounting for over one-third of equity trading volume in the United States.
  • Many studies of hedge fund performance document significant alpha in hedge fund returns, with estimates ranging from 3-5% annually
  • Proponents of hedge funds argue that the lack of regulation, unique organizational features, compensation arrangements, and manager skill are the primary reasons for their superior track record
  • An alternative explanation, however, is that the empirical estimates of hedge fund performance are overstated and come from biased data sources.
  • Hedge funds are not required to report their returns to any regulatory body, yet some funds voluntarily disclose their performance to data vendors, likely as a means of attracting capital.
  • Funds with poor performance have a strong incentive to withhold their returns from these databases.
  • Because studies of hedge fund performance only examine funds that choose to report, estimates of alpha are likely missing the worst performing hedge funds.
  • As a result, it may be that the superior performance of hedge funds documented in the literature is an illusion stemming from the self-selection bias inherent in hedge fund performance data.
The report found that "the self-selection bias in commercially available hedge fund data is severe", and "the average fund’s alpha falls to 5 bps/quarter". Far from excess returns of 3%-5%, this study suggests the actual excess return is 0.05% per quarter (1 bps = 0.01%. Financial markets like to talk in 'basis points' (bps) because a "50 basis point" swing sounds so much more dramatic than half a percent).

This 'self selection' of hedge fund performance data is demonstrated in the table below. The table shows the average investment returns of funds starting from the worst tenth of the funds, and moving up to the best tenth. The "Database Returns" are those reported by funds to databases used to provide industry wide return figures. The "Non Database Returns" include all figures, including those not reported to the database and which are therefore not included in industry-wide return figures.

The figures for the best funds are very similar - showing they all submit reports. The figures for the worst funds are very different, showing that many choose not to submit their results. Also, funds that fail and are shut down can be stripped out of the database entirely. This creates the extremely rosy picture fund managers like to paint about themselves to justify their fat fees.

***Below was added August 2012***
Table taken from a book by Simon Lack - "The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to Be True."

Comment about this table in a review of the book by Felix Salmon of Reuters:
"The main thing that you’re looking at here is the final line. If you look at the money that investors made by investing in hedge funds, it comes to $70 billion — a number substantially smaller than the $379 billion that the hedge funds managed to skim off in fees. Now the $70 billion is profit over and above the risk-free rate of return on Treasury bills. But it’s not the end of the story. Because funds-of-funds were very popular for most of this period, investors also paid some $61 billion to them. Which left them with the grand total of $9 billion in profits, compared to the $440 billion that the hedge-fund industry took in fees."


  1. Bruce Karpati, co-chief of the SEC’s asset-management enforcement unit, commented in relation to fraud cases the SEC filed against 3 hedge funds in December 2011:

    “Hedge fund managers depend on valuation and performance for both their compensation and marketing....These managers have either manipulated performance or engaged in other falsehoods in order to line their own pockets at the expense of investors.”

  2. In his book "The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to be True", Simon Lack calculates that of US$449 billion made by hedge funds "the cumulative split was just $9bn to investors versus $440bn to the managers and hangers-on. Even if you accept the industry’s argument that an otherwise adequate record of returns was undone by the 2008 meteorite strike, this still seems a crazy split. “Never in the field of human finance was so much charged by so many for so little,” is Lack’s wry comment."

    Book available here -

    Interesting Reuter's piece here -


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