'Sophisticated' Investors And The Hedge Funds They Love

By David Weidner

(Dow Jones) The market tumult of the last two years has taught us something about these so-called "sophisticated" investors we're hearing so much about these days: if we didn't know they were so smart, most of them could easily be mistaken for a bunch of dummies.

To be a sophisticated investor is not unlike becoming knighted. Loosely, a sophisticated investor is anyone - individual or institution-with a lot of cash who is anointed to play at Wall Street's high-rollers table. Regulators call them "accredited." Sophisticated or accredited investors know the rules and the game, maybe they have their own research arms or pay third parties to do their research. Maybe not. It's an exclusive club that allows anyone with a net worth of $1 million or more to play, and one that puts a greater liability on the investor.

But, as we've seen recently, many of them either don't do their homework, or are dazzled by the bright lights and shiny objects Wall Street dangles in front of them. When their investments go sour, some aren't too proud to tell regulators about being bamboozled or complain to the courts. Advisers say some also get right back in the saddle, thinking "this time it will be different."

That's the definition of crazy. How else to describe the sophisticated investor's loyalty to hedge funds?

These "exclusive" investments promise outsized returns and, perhaps, a certain cocktail-party cachet to the investors who qualify and join. But the reality is almost the opposite. Not only are funds extremely risky, they are preposterously expensive-usually 2% of assets under management and 20% of returns.

And those returns? Well, let's take a look at the record, limiting the query to the first four months of the year, before the flash crash, and the nadir of the European debt crisis. Through April, the S&P 500 Index was up 7.05% for the year due to a slow steady rise built on better economic data and corporate earnings.

During that span, however, hedge funds largely lagged the market. The HFN Hedge Fund Aggregate Index was up only 4.35%. The index added 1.55% during the month, nearly even with the 1.58% return for the S&P 500.

Those returns probably wouldn't entice most of us simpletons to dump our extra millions into the hedge fund asset class. But to "sophisticated" investors, flat-to-lower performance was an infectious, irresistible morsel. They looked at 4.35% like Chuck Schumer looks at a microphone.

"Sophisticated" investors pumped $7.67 billion into the asset class in April and $13.76 billion year to date. Cash flows into funds have been positive for the last 11 of 12 months, according to Channel Capital Group Inc. Six out of every 10 hedge funds had inflows in April, according to Hedge Fund Research.

OK. That's a small sample period, and the record does look better during the last two years.

Most of the indexes that track the performance of the asset class found hedge funds lost about 19% of their value in 2008, compared to a 37% loss for the S&P 500 that year. They fell just short of the market rally the following year -- performance acceptable from an investor perspective.

But remember, investors pulled money from hedge funds in 2008 and poured money into hedge funds last year, a year when average performance lagged the market.

And what did those investors really get? First they had to absorb the 2-and-20 fee structure. Then, they had to beat the odds. More than 1,000 funds, or one out of every 10, have closed since the high-watermark for the industry in 2007. So, the sophisticated investor had to be lucky.

They also didn't need the cash. Many hedge funds banned redemptions in the heart of the market storm, a policy that still holds today. Privately, hedge fund managers concede that new investments require a year lock-up at minimum. Some have longer time horizons: two years, three, even five.

Even in a shorter time frame, many hedge fund investors new to the game got pummeled. The hedge fund industry shed $638 billion in assets from its peak in the second quarter 2008.

Let's be fair. We're dealing with averages. That means some funds didn't do well and some did. Paulson & Co.? Their funds returned 19% in 2008 by betting against the mortgage market. David Tepper's Appaloosa Management recorded $7 billion in profit in 2009, mostly through buying down-and-out bank stocks. At Renaissance Technologies, James Simon's flagship hedge fund regularly racks up 35% annual returns.

On the other side are the spectacular losers. A fund run by Tontine Partners reportedly lost 91.5% in 2008. Bill Ackman's Pershing Square IV fund lost 68% the same year. Lancelot Investment Management closed five funds in 2008, lost 100%, ended in bankruptcy and allegations that it was a Ponzi scheme. Total loss, $1.8 billion.

Then there are the funds such as Raj Rajaratnam's Galleon Diversified Fund, it reported only a 3.04% loss in 2008, but that was before he was charged with insider trading and was forced to shut his operations down. Stanford Financial's assets added 30% in 12 months before it was shut down. Investors may get up to 20 cents on the dollar they invested with the company accused of being a Ponzi scheme.

Hedge fund closures are important. Whether or not they return money to investors, those closures-there were 2,394 in 2008 and 2009, according to HFR-and the losses they often generate for investors, are a forgotten part of performance measurement known among the index generators as "survivorship bias."

In other words, in the world of hedge fund measurement, it's the living who get counted.

Even then, studies found that hedge fund returns were only marginally better than the market. A 2007 study by John Griffin at the University of Texas and Jin Xu at Zebra Capital Management examined 24 years of data and concluded there was "weak statistical evidence" to hedge funds superiority relative to the market. The lackluster performance, the authors said "raises serious questions about the proficiency of hedge fund managers."

It's a wonder, given the low cost alternatives of investing with institutional brokers, buying ETFs or index funds, or -heaven forbid-investing alongside retail investors in mutual funds, that so-called sophisticated investors would return to the wellspring of hedge funds.

But they keep coming back, that's why they're smarter than us.