Are hedge funds long-term winners or riding their luck?
Investors in hedge funds should take a moment to consider the following. Imagine a budding professional gambler who meets with four friends each month for a poker game around his kitchen table. The players put in a dollar each and the winner takes home all of the money.
Such is his success his four friends soon tire of playing this card shark. Instead they decide to invest $100 each for him to play in a much bigger poker game in a casino. The agreement is that all five will split the profits between them, meaning the player gets a fifth of the winnings without risking any of his own money.
Sadly for all involved, when the player arrives at the bigger game he quickly sees the level of competition is far higher than at his kitchen table. By the end of the second year the player has lost half of the $400 he started with.
The first question is: what would his compounded annual return, expressed as a percentage, look like over the two years? The second question would be: is this gambler a long-term winner who deserved to be staked by his friends?
Hedge funds frequently market their services based on their percentage annual returns for investors after fees. The problem with the method is, like the poker player, it is possible to report impressive sounding annual percentage gains while having lost money over the long term investing in financial markets.
When hedge funds begin investing they start with small amounts of money. In order to grow in size they must make impressive returns on this small asset base to attract new investors.
Yet as they increase in size the amount of total dollars that can be lost or gained by a small percentage movement in their investments is greatly magnified.
As such there are hedge fund managers who lay claim to being super investors who have made double digit returns over many years but who have destroyed money in absolute dollar terms over their careers.
The method has proved controversial. Responding to a recent FT story on Mr Sopher’s list for 2015 some readers argued that ignoring annual percentage gains by the hedge funds was biased towards large investment groups managing many billions of dollars.
Bridgewater, the hedge fund at the top of the list, manages $154bn, meaning even an distinctly unimpressive percentage return will make it much more than a new fund running only $1bn.
Some investors in the list, such as John Paulson, made the bulk of their dollar returns betting successfully ahead of the credit crisis and have since then posted less impressive results.
Bill Ackman’s 40 per cent return in 2014 saw his Pershing Square fund leap into Mr Sopher’s all time list in the following year, with the hedge fund making $4.5bn in net gains for investors and $11.6bn since its launch in 2004.
At a time when larger funds are attracting a far greater share of new money than smaller start-ups it pays to look beyond simple annual returns when trying to judge whether a hedge fund is really a long-term winner, or is just riding its luck.