Are hedge funds long-term winners or riding their luck?

BEIJING, CHINA - AUGUST 27: A Chinese day trader plays cards wit5h others as he watches a stock ticker at a local brokerage house on August 27, 2015 in Beijing, China. A dramatic sell-off in Chinese stocks caused turmoil in markets around the world, driving indexes lower and erasing trillions of dollars in value. China's government has implemented a series of top-heavy measures to manipulate a market turnaround including its fifth cut to interest rates since November. Concerns about the overall health of China's economy remain amid data showing slower growth. (Photo by Kevin Frayer/Getty Images) *** BESTPIX ***©Getty
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.
The budding pro, through a mixture skill or luck, performs extremely well at the games and wins the $5 every month for year, or a total of $48 minus his own stake. Over the year he has turned his $12 stake into $60, or a 400 per cent return on his 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.
Rick Sopher, chairman of LCH Investments, compiles an annual list of the best performing hedge fund managers of all time based not on their compounded annual returns but on the amount of dollars they have made as investors over the lifetime of their funds.

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.
Another criticism is that the dollars made for investors method favours those hedge funds who may have had one blow out year.

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.
The LCH method shines bright lights on the hedge funds who make big bets that pay off, but also leaves those who make large losses on a big asset base with no place to hide.

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.
Since then a torrid time for Mr Ackman’s largest stock positions has seen him give back all of the money he made over that year. One year after becoming an all time great, he dropped off the list.

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.

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