Barton Biggs on Hedge Funds

When the financial world fell apart in 2008, hedge funds started to run for cover. Huge losses were rumored, the Madoff Ponzi scandal unfolded, a thousand hedge funds closed, and a number of large and famous funds raised "gates," or rules that block investors from getting their money back, at least for a while. Others turned to "side pockets," a trick that allows funds to move money-losing bets out of their portfolios for performance reporting. All this evasion enraged investors, and the demise of the business was forecast.

Today the industry is not dead, just growing old and fat. The post--crisis demands for reform have yet to impose clear reporting requirements on hedge funds, so the performance numbers remain very nebulous. But, in general, the biggest funds have delivered the best performance over the last 15 years: funds of $4 billion and above compounded at 15 percent per year, net of all fees. The smaller survivors delivered 12 percent, but including the dead funds in the calculation reduces the returns to just 6 percent. Over the same period, the S&P 500 Index returned 7.4 percent. An obvious conclusion is that unless you're with the biggest and brightest, you might as well buy an index fund. Of course, the real shocker came in the annus horribilis of 2008 when the median net performance was a loss of about 20 percent. There again, the big funds trumped the smaller ones.

Indeed, to the extent that the industry is growing again, it's doing so in a more conservative way, which could help foster market tranquility. The group Empirical Research Partners has assembled a database of the monthly performance histories of the majority of today's largest hedge funds, concentrating on volatility. It segmented the funds into high-volatility and low-volatility groups. Over the course of the last decade, the first group produced returns of 15 percent a year, but lost money in 34 percent of all the months. The second cohort generated 11 percent, but lost money in only 11 percent of the months. Guess what? The new money is mostly going to the low-volatility, lower-return group.

It's no surprise, given the number of investors who have become disenchanted with the industry. In the first half of 2009, rich individuals (who are the biggest investors in hedge funds) pulled out 40 percent of their money. This group believed hedge funds would actually make money in a bear market, because they had in 2000–03. These investors suffered from excessive expectations, and often had used funds of funds, which added another layer of fees. By contrast, the pension funds, endowments, and foundations that used specific hedge funds as an asset class in their portfolios did better.

Then along came the rally of 2009. The Dow was up 21 percent, and the S&P 500, 26 percent. Hedge funds did well, with the mean up 23 percent. For the last two years, according to Morgan Stanley, the hedge-fund mean is up 6 percent, the S&P is down 20 percent, the UBS Commodity Index is off 25 percent, the international index EAFE is off 15 percent, and private equity and real estate are still being sorted out. In other words, hedge funds worked better than almost all other asset classes.

So what's happening now? Wealthy individuals are still licking their wounds, and little money is going into traditional long-only equity mutual funds in the U.S. and Europe. However, money is starting to selectively flow back to hedge funds, particularly from institutions around the world. Startups that were all the vogue during the glory years are getting little money, and medium-size existing funds are seeing only a trickle. Instead, the flows are to the giant, lower-volatility funds, which could make the business more concentrated and professional.

Warren Buffett has famously said that he would take a bumpy 14 percent over a smooth 9 percent to 10 percent every time, almost suggesting it was irrational not to if you were a long-term investor. However, after the last decade (in which there were two killer secular bear markets with 40 percent–plus peak-to-trough declines), fiduciaries—who, by definition, should be long-term investors—are unwilling to ski the moguls and want smooth runs at a lower speed. Since pension funds have about 3 percent of their assets in hedge funds (and endowments and foundations, maybe 6 percent), there's obviously room for further growth, but mostly in the plain-vanilla end. The hedge-fund industry ain't dead yet; it's just going mainstream.