I am fascinated by what I have been calling the hedge fund paradox: For ages, all but the top funds have lagged behind benchmarks for one-, five- and 10-year holding periods. Despite this, many of these funds continue to attract a torrent of money.
Why is it that in the face of underperformance, investors still seem to love hedge funds?
I was reminded of this contradiction when I read in Bloomberg this rather astonishing figure:
The 20 most profitable hedge funds for investors earned $15 billion last year while the rest of the industry collectively lost $99 billion. Those top managers have made 48 percent of the $835 billion in profits that the hedge fund industry has generated since its inception. (emphasis mine).
Perhaps a more accurate headline for that famous Businessweek cover story should have been “All but 20 Hedge Funds Are for Suckers.”
I suspect that utterly mind-blowing data point is a large part of the reason for inflows: an ill-advised pursuit of market-beating alpha by investors who seem to be desperate to find the next James Simons.
We have looked deeply at why hedge funds underperform and can ascertain few concrete reasons why investors continue to hand over their money. Is it ego, Davos cocktail party bragging rights or something deeper and more significant? I have my own theories, but I lack hard proof.
Regardless, there are no signs of it slowing down. That isn't to say a rotation within the hedge fund firmament is not taking place. Just as their less well-heeled investing cousins in mutual funds chase the latest hot hand, the disappointed limited partners in hedge funds also seem to be a fickle group. Like speed daters looking for Mr. or Ms. Right, they table hop in pursuit of the one manager who has the secret sauce to make the wealthy accredited investor even wealthier.
The data overwhelmingly suggest this is a futile pursuit, for individuals and institutions alike. No one seems to have cracked the simple puzzle: How can we identify in advance those unheralded managers who are likely to generate alpha in the future.
The latest hot hand to have cooled down is John Paulson: As Bloomberg reported, the billionaire hedge fund manager has been “struggling with uneven returns since his windfall wager against U.S. housing in 2007, is turning to his own fortune to help backstop his firm,” and has pledged his personal wealth as collateral for a credit line for his firm, Paulson & Co.