Celebrating the Rich Stealing from the Rich

Maybe it’s because I was born near the Sherwood Forest, in Nottingham England, but I get a kick out of stories where wealthy people fleece each other. Call it my Robin Hood Syndrome.

Take Hedge Funds for example. As the investment vehicle for many wealthy, accredited investors, they capture headlines and tickle greed buttons around the world.

“Ahhh, if only I was wealthy enough to have access to a Hedge Fund Manager. My money would do so much better.” If that’s you, breath easily. You’re statistically far better off picking stocks on your own or buying an index fund.

With no regulations to speak of, Hedge Funds can bet against currencies, or bet against the stock market. If the market falls, a Hedge Fund could potentially make plenty of money if the fund manager “shorted” the market. With the gift of having accredited (supposedly sophisticated) investors only, Hedge Fund managers can choose to invest heavily in a few individual stocks, while a regular mutual fund has regulatory guidelines with a maximum number of eggs they’re allowed to put into any one basket.

For some reason, despite their supposed exclusivity, some of my friends have been sold on Hedge Funds in recent years. Advisors and salespeople have convinced them to invest in these high cost products that can make fortunes for the people running them. But generally speaking, they’re still the exclusive playgrounds of the rich. And if you’re entertained at the thought of one rich person (a Hedge Fund manager) robbing another rich person (a Hedge Fund buyer) then read on.

The typical Hedge Fund charges 2% of the investors’ assets annually as an expense ratio, which is pretty high. But then they take 20% of any investors’ profits. It’s a license to print money off the backs of those hoping for high rewards.

Hedge Funds voluntarily report their results, which is the first phase of mist over the industry. The Economist, for one example, reports the average (unaudited) returns of Hedge Funds in the back of each issue, while comparing it to various world indexes. Generally, the Hedge Funds compare favorably—from what I have seen—by a consistent percentage or two above the indexes.

But The Economist doesn’t crunch the numbers for the Hedge Funds that go out of business. They only report the results of those that remain. So what’s the attrition rate for these envious investment products?

When Princeton University’s Burton Malkiel and Robert Ibbotson, from the Yale School of Management, examined Hedge Funds from 1996 to 2004, they reported that fewer than 25% of them lasted the full eight years. Would you want to pick from a group of funds with a 75% mortality rate? I wouldn’t.

When looking at reported, average Hedge Fund results in The Economist, you only see the results of the surviving funds—while the constantly dying funds don’t go into the averaging. It’s a bit like a coach entering 20 high school kids in a district championship cross country race. Seventeen of them drop out before they finish, but your three remaining runners take the top 3 spots. So then you report in the school newspaper that your average runner finished 2nd. Bizarre? Of course, but in the fantasy world of Hedge Fund data crunchers, it’s still “accurate.”

As a result of such twilight zone reporting, Malkiel and Ibbotson found, during their 8 year study, that the average returns reported in databases, (the results of which you can see at the back of The Economist each week) were overstated by 7.3% annually.

That includes survivorship bias (not counting those that don’t finish the race) and something called “Back-Fill Bias”. Imagine 1000 little Hedge Funds that are just starting out. As soon as they “open shop” they start selling to accredited investors. But they aren’t big enough or successful enough to add their performance figures to the Hedge Fund data crunchers—yet. That’s the dream.

After 10 years, assume that 75% of them go out of business—which is in line with Malkiel and Ibbotson’s findings. For them, the dream is gone. And it’s really gone, for the people who invested with them.

Of those (the 250) that remain, half of them have results they’re proud of, enabling them to grow and tout their track records. So out of 1000 new Hedge Funds, 250 remain after 10 years, and 125 of them grow large enough (based on marketing and success) to report their 10 year historical gains to the data crunchers compiling Hedge Fund returns. The substandard or bankrupt funds don’t get “number-crunched” and the new entries into the databases report their 10 year track records. Ignoring the weaker funds and bringing forth only the strongest ones—while taking their ten year track records into the number-crunching— is called “Back-Fill Bias”.

Doing so ignores the mortality of the dead funds and it ignores the funds that weren’t successfully able to grow large enough for database recognition. So these few funds go into the figures reported by magazines like The Economist, and their 10 year returns are averaged along with the other “live funds” in the database. Malkiel and Ibbotson’s study found that this bizarre selectiveness spuriously inflated Hedge Fund returns by 7.3% annually, during their 8 year study.

(Swensen, Pioneering Portfolio Management pg. 195).

To make matters even worse, Hedge Funds are remarkably inefficient after taxes, based on the frequency of their trading.

Hedge Funds are like hedgehogs. Nice to look at from afar, but you really don’t want to get too close to their spines. You’re far better off in a total stock market index fund.

And you can watch the rich stealing from the rich—from the other side of the fence.

Andrew Hallam

I’m a financial columnist for Canada’s national paper, The Globe and Mail, as well as for AssetBuilder, a financial service firm based in Texas. I’m also the author of Millionaire Teacher: The Nine Rules of Wealth You Should Have Learned in School and Millionaire Expat: How To Build Wealth Living Overseas. My mission is to educate, motivate and inspire people on basic retirement planning and best practices for investing, using evidence-based strategies. I'm happy to comment on your questions.

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23 Responses

  1. Kevin@InvestItWisely says:

    Again, I think it comes down to funny money. How well would these funds do without funny money… I imagine probably close to 100% would go bust. I would almost say that funny money could even be responsible for gold's rise. That depends on how many people borrowed US dollars to speculate with, though, and those are numbers I don't have off the top of my head.

    Whenever I've checked recently, there has been more selling than buying, but the fall of the US dollar caused the overall price to go up, anyways.

  2. Kevin@InvestItWisely says:

    P.S. they do have quite the reputation. Some people think they are some kind of "secret investment club" just for the rich, where they can get more than 20% per year. Perhaps if you get lucky and roll two doubles…!

  3. Hey Kevin,

    What do you mean by funny money? And how do you think it's responsible for gold's rise?

    On a fun sidenote, I calculated what $1 invested in gold in 1801 would be worth on Friday, when gold hit what I believe was an all-time high.

    $1 invested in gold in 1801 would have been worth $48 last Friday (August 24, 2010)

    $1 invested in the U.S. stock market in 1801 would have been worth $9.3 million (August, 24, 2010)

    Gosh, gold is catching up!

  4. @Kevin@InvestItWisely

    Hey Kevin,

    Did you know that the results of Long Term Capital Management didn't go into the data crunchers when they went belly up and nearly brought the world's financial markets with them? According to the New York Times, Tremont Capital Management (a leading purveyor of hedge fund data) contains Long Term Capital Management's results only through October, 1997, nearly a full year before the collapse of LTCM.

    As a result of that, the official recorded return in Tremont's data base for LTCM was 32.4% per year. But the actual total result was a loss of -91.8%. This true result lies nowhere in Tremont's data. (Swensen, Pioneering Portfolio Management, pg 194).

    Kevin, you'd love this book. It might be tough to find, and it was written for endowment fund managers for the most part, but it's simply awesome!

  5. Buffett bet Protégé Partners LLC, a New York City money management firm that runs funds of hedge funds, roughly $1M that the average return of five of their funds of funds after all fees, costs, and expenses are deducted will not beat the market index over a 10 year period starting in 2008. I bet Buffett wins, and the über-rich get fleeced.

  6. @The Biz of Life

    Hey Biz,

    I think he'll win too. But I wish he also placed the wager after taxes. There's no way the after tax hedge fund collection is going to be anywhere near as tax efficient as the S&P 500 index. In a fully taxable account, the average actively managed fund has a taxable drag exceeding a market index by roughly 1.3% annually. The tax-efficient advantage for an index versus the average hedge fund would have to be 2% annually. What do you think? So after taxes, I think the average hedge fund would have to beat a total market index by 2% annually, just to keep pace. And studies suggest that, as an aggregate, hedge funds tend to be far worse than actively managed funds.

  7. I've always said Hedge Funds exist solely to make the people that run the hedge funds obscenely rich, not to enrich the investors in those funds.

  8. larry macdonald says:


    Great post. I wasn't aware of the extent of survivor bias etc.

  9. Great post Andrew.

    Based on my readings and personal experience, almost every financial product is designed the same – to maximize return for the product provider (company); not the client (investor).

    The only way to avoid this, is to become a highly diversified (stock) owner yourself; own the market (lowest-possible cost indexed ETFs like some iShares and Vanguard) or use a mixture of both.



  10. @The Biz of Life

    Hey Biz,

    At our school's "career day" a few years ago, I met a woman who sells Hedge Funds, among other investments, to high net worth Americans. We chatted after her session, and then I asked her how she felt about the average Hedge Fund losing to something so simple as the S&P 500 index. That's when she brought out her data. Then when I went into talking about survivorship bias, backfill bias and taxes, she was completely lost. Oh—except for the tax part. You're going to love this. She said her clients don't pay taxes because they keep their money offshore. As an American, you know that there's nowhere to legally hide from the IRS. So she promoted expensive products that were closer to lottery tickets than investments, and she promoted illegal tax evasion. Sweet. She was a nice woman. But wow!

  11. @larry macdonald

    Thanks Larry,

    I was utterly amazed when I read about Malkiel and Ibbotson's study. If you get a chance to check our David Swenen's book, Pioneering Portfolio Management, you can read about it there, on page 195.

  12. @Financial Cents

    Thanks for the comment Mark,

    And I totally agree with you. If I was a mutual fund managers or a financial advisor (not fee-based only) I wouldn't be able to gain a lot of job satisfaction. But as I recently read, most people don't go into portfolio management to help people. Their prime directive is the money. And I don't think most advisors even know this stuff, considering how limited their training is. Most advisors, then, are used by their respective mother ships.

    The honest ones who do know this stuff charge by the hour for advice.

    What do you think Mark?

    And if you're a financial advisor, and reading this, what do you think? Other than giving people a push to save, I don't think most advisors offer a service that an accountant couldn't offer (and at a smarter, better overall rate, I might add, after all fees are accounted for)

    I'd love to hear a financial advisor claim that they're worth more than that to a client. If you're in the business, selling expensive active products, I'd like to hear from you.

    Thanks again for the comment Mark.

  13. DIY Investor says:

    @Andrew Hallam

    Interesting fact about LTCM and Tremont data. I have often wondered how the implosion of the world's largest hedge fund didn't seem to be reflected in the numbers bandied around.

  14. @DIY Investor

    Hey Robert,

    If Ibbotson and Malkiel's study is correct, none of the other relative implosions affect Tremont's data either. Any ideas why not?

  15. Hey Andrew,

    The problem with money is that it is not a very good measure of value. People celebrate when the Dow goes up 300 points, but they failed to realize that the dollar dropped at the same time. They are not measuring with a constant ruler.

    With all of the recent interventions, money has become very funny. Alan Greenspan and his low interest rate policies helped fuel a mother of a housing bubble, and all of the recent quantitative easing is distorting the markets further.

    Then you have Korea, Japan, Brazil, etc… threatening to devalue their currencies (and some of them doing it) in order to keep their currencies from appreciating too much against the US dollar. This causes the US dollar index to rise, but the net effect is that the affected currencies are now weaker against goods and services.

    The problem is that if you are not careful, you can confuse true prosperity with the effects brought on by a weakening dollar. The problem is that people believe that the markets are getting longer, but in reality, it's their ruler that is getting shorter.

    Coming back to gold, it may be in a bubble, but much of the story is due to a change in the length of the paper ruler. Like other commodities but unlike paper assets, its value is more difficult to manipulate. Until every man, his dog, and his parrot as well are buying up gold, I don't see it in the maniac stage of bubbledom. During the peak of the housing bubble, EVERYONE was bragging on how easy it was to make money by flipping houses. They were making the rest of us feel pretty stupid at the time. It must have been a case of collective madness. 😉

  16. Oh, I hear you when it comes to "investing" in Gold. My personal view is that gold should be seen as a complementary asset. An all-stock portfolio probably beats bonds, too, over the very long run, but few people would go with a 100% stock.

    This is market timing in some sense, but if you adjust your asset allocations based on fundamentals and outlooks, you would have beaten a 100% stock portfolio. Someone in the early 1970s would have borrowed long-term debt at low-rates and would have annihilated the stock market. I imagine that people that bought bonds at 20% or so probably didn't do too badly in the years that followed, either?

    Likewise, if you looked at the gold price back in 2002 or so and took a contrarian position there, you would have outperformed the stock market over those years.

    This is easy to say in hindsight though. If we don't look at this kind of shifting around and stick to comparing fixed portfolios, then over the long run an all-equity portfolio, or perhaps mostly stocks with a few bonds probably does beat everything else. I remember that the retirement PDF you sent me came to the conclusion that if time and variance are not factors, the higher the equity allocation the better. The problem is that since time and variance are factors, a black hole event like the depression just before you planned to retire hurts you a lot…

    What do you think, though? Do you think that it's possible to look at fundamentals and make a bet based on that, or that people who decided to start allocating into gold in the early 2000s were simply speculating and got lucky? Since nothing about the future is certain, I suppose there is some truth to that as well.

  17. Hey Kevin,

    I think it's easy to look backwards at speculators and suggest that they were more talented than lucky. We can look at, perhaps, the world's smartest investors—-the guys running hedge funds. They can dance around all they want: into commodities, gold, equities, short the market, whatever suits their fancy. And most of them have the training that goes along with that. And yet…their funds have a 75% mortality attrition. After backfill bias and survivorship bias, they certainly appear to possess no skill whatsoever, as a group. Considering that they're well-trained (in most cases) the fundamental moves that you're talking about might be akin to somebody watching a group of gamblers at a casino, and tracking what they did to win at the roulette table, and then make a fundamental assumption based on the patterns of what looks like a playbook. Too many smart people waste their time with that, when it comes to the stock markets. I really don't think dancing into oil or gold or pink ribbons at the right time is "winning" on fundamental brilliance—just luck. The smart investor, I think, really can balance between stocks and bonds. And they'll beat 95% of the "smart money" dancing everywhere, based on fundamentals (like the Hedge Fund guys)This thing with gold is going to make investors think they should be doing that too, but this is where money plays with them and convinces them to start making up new rules to deal with something somewhat aberrational, that to the speculator, is rationalized as something entirely fundamental. I totally agree with what you're saying about funny money. That's what I thought when oil was shooting up a couple of years back. Much of that rise was coming from a falling U.S. dollar. An Australian stock index, when measured in U.S. dollars, is certainly looking like a rocket at the moment too.

  18. Kevin@InvestItWisely says:

    I think you're right about most speculators — after all, many were calling for $250 oil at one time. However, I do believe there is some room for fundamental analysis when one looks at some factors: China's growing population and resource consumption, dwindling production, and increasing demand.

    Likewise with gold, there are fundamental factors at play such as the ever-present manipulation of paper assets, and one can take a position based on these factors. Precious metals and oil maintain their value when paper assets fail.

    Nonetheless, I agree with you that broad-based indexes at the lowest cost are the least speculative ways of investing. With gold, oil, or anything else, there is always the risk that some speculator's make-believe fantasies get confused for reality.

    That is why I am still mostly in equities. I do see the case for resources and precious metals, but I acknowledge that my exposure to risk is heightened and that there is more speculation involved here. I do believe that my play is +EV, and I expect to see some positive value out of it. I am not risking my portfolio on it, though.

  19. Kevin@InvestItWisely says:

    P.S. I made the mistake of getting caught up with emotions when I sold at the last peak. I'm sure you remember that time. 😉

    I've learned my lesson and I now take a more mechanical strategy of a ~10% allocation, which I reserve the right of reducing if I feel that governments are starting to develop some common financial sense once again. Like in the 1970s and 1980s, we COULD see a turn around in policy. If we see a doubling in gold price like in 1980, I'll have sold off half of it to buy what will probably be cheap stocks. I like what you have written so far about value averaging, and I plan to be implementing more of it down the road.

  20. Kevin@InvestItWisely says:

    This guy says it better than I do.


  21. Hey Kevin,

    Thanks for that link. It's interesting stuff. And how did you find your guest poster? He wrote a fine piece? Have you ever had someone offer you "canned" guest pieces: boring ones that say nothing? I've been offered a few of those, and I can tell that they're always written by someone else. And the person wanting me to post it is always in a state of emergency. Is this a bizarre bi-product of the blog world?

  22. Ooops, forgive my question mark. He did write a fine piece, and I'm too illiterate (tech-wise) to edit that question mark. Ahhhh. I need to retire in the woods and avoid tech.

  23. @Andrew Hallam

    I have gotten plenty of the canned pieces. I just ignore those emails completely now. In fact, you might get a kick out of reading my post about those guys here 🙂 : http://www.investitwisely.com/the-guest-post-a-de

    The more legitimate guys will provide references to a decent personal finance blog, and often links to other guest posts that they have done as well. Greg approached me, and I received great feedback after I asked some fellow PF bloggers what they thought about his guest posts. The post itself was pretty good, too, so it was very easy to publish it after that.

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