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.