Does the Hedge Fund industry benefit society? by Don Steinbrugg, CFA
It is no secret that the hedge fund industry is viewed negatively by a large portion of the general public, but should it be? Such a perception is driven primarily by the fact that most hedge funds are not permitted to market themselves to the general public, and because the mainstream media has a negative bias toward their coverage of the industry. The average person is inundated with negative articles creating the image that: 1.) Most hedge fund managers are dishonest and frequently commit fraud or violate insider trading laws. 2.) Hedge funds are highly risky investments. 3.) Their devious actions are bad for the general public. 4.) Hedge funds generate bad performance and their fees are too high.
Is the general’s public perception of the hedge fund industry equal to reality? Let’s take a closer look at each one of these points:
- Is the average hedge fund manager dishonest? Of course not. The industry is not comprised of a bunch of Bernie Madoffs, as many people would believe. Agecroft Partners estimate that there are more than 15,000 hedge funds in the market place and a vast majority of these are run by honest business people trying to do the right thing for their clients. The reality is that multiple times more money has been lost by investors due to fraud in public equities and fixed income securities. Some of the largest frauds in history included Enron, WorldCom, Tyco International and Health South. There is not enough room in this paper to include all the penny stock companies that have gone out of business.
CEOs of publicly traded companies are heavily biased in articulating the future prospects for their company and often there is a large grey area relative to what is stretching the truth and what is crossing the line. When was the last time a CEO did a road show and said “our products are really bad, our head of R& D is completely incompetent and I am over my head in this position. This is a great time to short our stock.” If this is the case, why must hedge funds include disclosures in their presentations that are slightly less scary than what appears on cigarette packages while buying a publicly traded stock does not?
- Are hedge funds risky? The answer to this question depends on the definition of risk. The average volatility of hedge fund indices is a little more than half the volatility of equity indices. Relative to downside risk, in 2008, the MSCI world stock index was down over 40% which was more than double the decline of the average hedge fund.
Typically, owning an individual stock has significantly more downside risk than an individual hedge fund which owns a diversified portfolio of securities. In 2008, many companies’ stock price declined 90% to 100% in value over a short period of time, which included such prominent companies as Bank of America, Lehman and Merrill Lynch. Many institutional investors are increasing their allocation to hedge funds in order to reduce the overall volatility of their portfolio. Not only does a diversified portfolio of hedge funds have a lower volatility than an equity portfolio, it also can provide low correlation to other asset classes which reduces overall portfolio volatility.
- How does the Hedge Fund industry benefit society?
- The stability of the hedge fund industry has become important to the global economy as hedge funds have replaced investment banks in many cases as a major provider of liquidity to the capital markets due to the Dodd-Frank legislation. Companies cannot operate without access to capital, which is dependent on free flowing capital markets. If the capital markets seize up, the global economy slows, and people begin to lose their jobs. This can create a downward spiral. Global central banks provide liquidity to their respective economies, but hedge funds are also providing a valuable service as the buyers of last resort of securities no one else wants to buy. The stability of the hedge fund industry has increased significantly since 2008 which is a positive to the world economy.
- Hedge funds provide capital to many small and mid-sized businesses who have difficulty getting financing from banks. Hedge funds are making more direct loans and equity investments in small to mid-size companies that cannot get financing from traditional sources. This allows them to expand their business and hire more people.
- The hedge fund industry is a major employer of high paying jobs. In addition, there are a number of industries heavily dependent upon the hedge fund industry including wall street investment banks, commercial real estate, accounting firms, law firms and administrators. We estimate that there are more than 250,000 thousand people in North America alone either directly or indirectly employed by the hedge fund industry.
- Hedge funds and their employees pay a large amount in federal, state and local taxes that help pay for vital services for the people within those localities. Using simple math, the hedge fund industry currently has approximately $3 trillion in assets earning on average a 1.5% management fee and 20% of performance fee. This generates approximately $90 billion in revenue based on a conservative return assumption of 7% annual net performance. Most of this revenue is attributable to salaries and firm profits which generate a massive amount of taxes.
- Hedge Funds contribute large amounts to non-profit organizations each year that benefit society. This includes everything from organizations that benefit the homeless, children, world hunger, the arts and education. For example, last year the Robin Hood Foundation, which was created by hedge fund managers, gave $132 million to 210 poverty-fighting programs in NYC. In addition to contributing money, many hedge fund managers also volunteer their time by participating on boards of various non-profit organizations.
- Uncorrelated returns. The hedge fund industry consists of many different strategies with varying degrees of correlation relative to the capital markets. During major market corrections, correlations tend to rise. Hedge fund strategies with low correlations to the capital markets have historically added valuable diversification benefits to portfolios.
- Do hedge funds generate performance that justifies their high fees? HFR estimates that investors allocated $76.4 billion of new capital to hedge funds globally in 2014. Based on the fact that the hedge fund industry assets are close to their all-time peak, investors are answering this question by voting positively with their assets in increasing their allocations to hedge funds. In addition, most of the money flowing into the hedge fund industry is coming from large institutional investors which arguably could be classified as the most sophisticated investors. AIMA wrote a paper last year that reported hedge funds consistently outperform the S&P 500, MSCI World and Barclays Global Aggregate ex-USD Index on a risk-adjusted basis. Even during the stock-market rally of 2009-2013, hedge funds performed better on a risk-adjusted basis than the S&P 500 and MSCI World. Please also see Agecroft’s white paper Why are hedge fund assets reaching all-time highs while they underperform the S&P 500?
The hedge fund industry is not perfect, but neither are the capital markets, which is why we have numerous regulators around the world overseeing the industry.The bottom line