The recent release of Institutional Investor Alpha’s hedge-fund survey has everyone asking how the fund managers continue to make so much money. Academics and journalists alike point out that hedge funds, as a class, haven’t delivered above-market after-fee returns for quite some time.
Hedge funds, of course, get paid whether the market goes up or down, so the real question is why hedge funds continue to receive large inflows of capital from pension funds and other investors. So why would people expect hedge funds to deliver superior returns in the first place?
People often seem to treat the term “hedge fund” as if it’s shorthand for “money manager of unusual skill.”
But “hedge fund,” after all, is just a legal category. There are regulations governing what kind of assets a fund is allowed to trade, and what kinds of clients the fund can service. Hedge funds are only allowed to sell to certain types of investors – rich people, large institutions and those who qualify as so-called sophisticated investors.
In exchange for this limitation on who can invest in them, they are exempt from most restrictions on what kinds of assets they can trade and how much leverage they can take on.
Theoretically, this exemption should mean that hedge funds offer the potential for diversification. Since they can invest in things other funds can’t, buying into hedge funds can theoretically give an investor access to a wider universe of assets.
But beyond that, there is little reason to believe that hedge funds as a group offer anything special. After all, any Tom, Dick or Harry can start a hedge fund. That’s right – all you need is a business license That’s called “free entry.” In economics, free entry means that average profits in an industry (net of opportunity cost) should be competed away to zero.
In other words, if a pension-fund manager or rich investor hurls his money at a fund just because it’s called a “hedge fund,” he isn’t making a sophisticated, market-beating choice. He is paying through the nose to take a lot of risk and get a bit of diversification. Thus, it’s no surprise that during the past couple of decades, even as money has continued to flow into hedge funds, their return hasn’t impressed.