Hedge funds have become the superheroes of the invest-
ment world, producing outsized returns using a combination of rocket science and leverage. Of course, there's a darker side, as evidenced by the 1998 unraveling of Long-Term Capital Management, and to date companies that sponsor defined-benefit pension plans have been wary. But as plan sponsors struggle to remedy funding shortfalls, more and more are considering investing in hedge funds.
Are they signing on just as the kryptonite starts to take effect? Hedge funds results overall in 2004 were disappointing, leading to talk that all the money pouring into the sector was resulting in diminished returns. There's also some question about the validity of statistics on past hedge fund returns. Princeton University Professor Burton Malkiel and Atanu Saha of Analysis Group Inc. have released a paper arguing that indexes overstate hedge fund returns, in part because so many hedge funds go out of business and the indexes neglect to capture data about the failed funds.
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The claim that hedge fund returns are overstated isn't new, although Malkiel's paper puts the overstatement close to 400 basis points, far bigger than previous estimates. Robert Schulman, co-CEO of Tremont Capital Management Inc.–its data is analyzed in the paper–says that the claim is "preposterous." Malkiel and Saha assume that funds that drop out of indexes do so because they failed, Schulman says, when in fact many do so because they're no longer accepting new money. David Tsujimoto, director of alternative investments at Russell Investment Group, says there are various problems with hedge fund indexes, including survivorship bias, but the same problems exist with mutual fund indexes. More importantly, Tsujimoto says, the investable hedge fund indexes that have emerged in the last few years provide a more accurate way to assess hedge fund returns. An investable index "eliminates a lot of the problem with survivorship bias and creates a track record that you can actually replicate," he says. A Merrill Lynch index of investable indexes showed an average 2004 return of 5.67%.
But if lots of new funds are all trying to mine the same set of investment strategies, won't hedge fund performance suffer in the future? Tremont's Schulman says that the amount of money going into hedge funds could eventually lead to diminished returns, but that that hasn't happened yet: He estimates that hedge funds control about $1 billion, with $400 million to $500 million of that in equities, and argues that that sum is inconsequential given the $42 trillion of global equities outstanding. Schulman blames the unimpressive 2004 returns on unfavorable market conditions like low interest rates and volatility. Other experts say that certain hedge fund strategies may be played out, either because too much money is chasing those opportunities or because current market conditions aren't suitable for a particular strategy, and that investors just need to identify the right strategy. "It's clear that in some sectors, the opportunities have diminished because too much money has gone into them," Tsujimoto says. "But I don't think it's true across the board."
In any case, a lot of the appeal of hedge funds for institutional investors has to do with the fact that their results aren't tied to the markets' performance, consultants say. Particularly in a down market, that lack of correlation provides a cushion for investors. They also note that a lot of very talented fund managers have migrated to hedge funds. "Some of best minds in investing are going into the hedge fund world," says William Wechsler, a vice president at Greenwich Associates.
Of course, new investors face the daunting task of sorting through the 7,000 or 8,000 hedge funds and their complex strategies. One common way to start is by investing in a fund of funds; such funds seek out the most promising hedge fund strategies and portfolio managers. Wechsler notes, though, that using a fund of funds adds another layer of fees to the already high fees charged by hedge funds. But investors may need some assistance, especially since it's not enough to find just a few suitable hedge funds. "With this area, you do need a lot more diversity," says Russell's Tsujimoto. "Even if you're making only a 5% allocation to hedge funds, our research suggests that needs to be divvied up among at least 20 funds."
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