The Problem with Hedge Funds

 |  Includes: C, GS, JPM, LEH, MER
by: Tsachy Mishal

Before I outline what I think is wrong with the hedge fund industry today, I would first like to mention that some of the investors I aspire to the most are or were hedge fund managers. People like Michael Steinhardt, Steve Cohen, Julian Robertson, George Soros and Doug Kass. At the time these mangers started in the hedge fund business, they were mavericks who were fighting against the institution. The problem is that hedge funds have become the institution.

Twenty five years ago, hedge funds were not on too many people’s radar. Most people invested through mutual funds or brokers. The pioneers of hedge funds believed that there was a better way and made money by setting themselves aside from the crowd. Their successes brought much attention and popularity grew over the years.

Throughout history, investors chased returns and this time was no different. Today, there are thousands of hedge funds. It is estimated that 40% of the volume on the stock exchange is attributed to hedge funds. How can hedge funds beat the market when they are the market?

Hedge funds have been hiring analysts from Wall Street, mutual funds and MBA programs where brokerages generally hire. Study after study has shown that Wall Street brokerage recommendations lag the market. In addition, studies show that that the vast majority of mutual fund returns lag the market as well. So why does anyone think that moving Wall Street analysts, mutual fund analysts, and MBAs to hedge funds will produce better results? In addition, Wall Street banks, including Lehman Brothers (LEH), Goldman Sachs (NYSE:GS), Citigroup (NYSE:C), JPMorgan Chase (NYSE:JPM) and Merrill Lynch (MER) all owned or own stakes in hedge funds. These were the institutions that the original pioneers tried to set themselves apart from.

There is increasing evidence that hedge funds are engaging in the same herding behavior that has hurt investor’s returns in mutual funds and from following brokerage recommendations. A recent Goldman Sachs report analyzing hedge fund positions show that as a group, hedge funds' positions are concentrated in the same sectors and stocks. There are many great hedge funds out there, but as a group they are not impressive.

In the past, hedge funds have produced superior results because they were different and had people who were uniquely qualified for the business. A hedge fund is not successful because it is called a hedge fund. Yet, that is what people assume when they invest based on the historical returns of hedge funds. By comparing the hedge funds of yesterday to the hedge funds of today, investors are comparing apples and oranges.