Are hedge funds a good investment? To answer this question, we can look at three well known funds as case studies. The first is Renaissance Technologies.
Renaissance was founded in 1982 by an academic named James Simons, who had been chair of the math department at Stony Brook University and, before that, a code-breaker for the U.S. military. Because he didn’t have a background in finance, Simons instead relied on mathematics, developing the first purely computer-driven trading system. The result: As his biographer put it, Renaissance “solved” the market. Over a roughly 30-year period, through 2018, Renaissance delivered average returns of 66% per year. By way of comparison, the S&P 500 returned 10.2% per year over that same period. When Simons died in May, his net worth was in the billions.
The second fund we can look at is Long-Term Capital Management (LTCM). Unlike Renaissance, the founders of LTCM were all well known figures in finance. John Meriwether had been vice chair of Salomon Brothers, while Robert Merton and Myron Scholes had been finance professors at MIT. Merton and Scholes later shared a Nobel prize in economics, and for several years, LTCM’s performance reflected this pedigree. Relying on highly-engineered bets, mostly on bonds, LTCM’s returns in its first four years averaged 38% per year, about 15 percentage points ahead of the S&P 500. But in 1998, one of the firm’s bets went wrong.
In isolation, a single bad trade wouldn’t have been a problem for Long-Term Capital, but it was highly leveraged, and that left it little room to maneuver. Its leverage ratio was 28-to-1, meaning it had borrowed $28 for every dollar it had on hand. Thus, a small miscalculation caused the firm to become insolvent in a matter of days.
Ironically, because it had borrowed so much from so many other firms on Wall Street, LTCM was in the “too big to fail” category. Fearing that its web of debt might drag down other firms, the Federal Reserve Bank of New York coordinated a group to take over Long-Term’s assets, allowing for an orderly liquidation. But investors lost essentially everything. That was more than 20 years ago, but it remains one of the most well known failures on Wall Street. The definitive account of Long-Term Capital was titled, fittingly, When Genius Failed.
The third fund we’ll look at is Integral Investment Management. Unlike the group of professors who founded Long-Term Capital, Integral’s founder was more unconventional. Conrad Seghers held a Ph.D. in biology and had only limited trading experience. But his firm got off to a fast start. It claimed not to have had a single losing month and, as a result, “the highest Sharpe ratio in the industry.” The Sharpe ratio is intended as a measure of a fund’s returns adjusted for its risk level. Impressed by these metrics, investors including the Art Institute of Chicago invested tens of millions with Seghers. But it didn’t end well. Most of the fund’s value vanished in a short time, and Seghers was ultimately convicted of securities fraud.
What do these three funds have in common? Knowing how things turned out, they couldn’t have been more different from one another. But in their early years, that would have been difficult to see. They might have looked quite similar. Indeed, of the three funds, Renaissance might have even looked like the least promising. In contrast to LTCM and Integral, which were fast out of the gate, Renaissance stumbled. In its first year, Renaissance underperformed the S&P 500 by seven percentage points, and in its second year, it trailed by an even wider margin of 34 points.
It was only later that investors were able to see the differences—that Renaissance was on its way to becoming the most successful investment fund ever, while LTCM was a house of cards, and Integral was a fraud. This highlights one of the key risks of hedge funds. Because they aren’t subject to the same scrutiny as publicly-traded funds—and are often pursuing esoteric strategies—hedge funds can be black boxes. Investing, to a degree, becomes an act of faith. This lack of transparency is a key reason I don’t view hedge funds—and private funds in general—as a good idea for individual investors.
Private funds pose other challenges too. In general, they carry higher fees and are less tax-efficient than standard, publicly-traded funds such as mutual funds and exchange-traded funds (ETFs). Private funds also limit withdrawals in ways that can pose challenges to even the wealthiest of investors.
But all of those challenges with private funds are, to an extent, manageable and might even be tolerable. A much more significant challenge, however, is access. Specifically, the best funds aren’t open to individual investors. That’s because of their structure. Private funds are eligible for a valuable exemption from registration with the Securities and Exchange Commission, but only if they have fewer than 100 investors. As a result, funds with strong track records can be choosy in who they allow to fill one of those 99 slots. And typically the investors they’ll choose are the ones that are able to write the largest checks. More often than not, that means university endowments and large foundations are first in line. Individual investors, even if they can write six- or even seven-figure checks, have a hard time competing with institutional investors who can afford to put $10 million or more into a single fund. Thus, individual investors who want to invest in private funds are, almost by definition, relegated to inferior options. In contrast, the best-performing publicly-traded funds are almost always open to new investors.
This issue is compounded by another difference between public and private funds: The performance gap between the best and worst private funds is much wider than the corresponding gap between the best and worst public funds. To put it another way, for all the hand-wringing over the differences between high-cost actively-managed mutual funds and low-cost index funds, that difference pales relative to the differences between the best and worst private funds.
In a study by the investment firm Blackstone, the difference between top-quartile and bottom-quartile public funds was less than two percentage points. But the difference between the best and worst quartile private funds was significantly wider—as much as 15 points. Cambridge Associates, a consulting firm that advises on private funds, describes the dispersion among private funds as “immense.” At the end of the day, that dispersion gap is, in my view, the most important reason why individual investors are best served sticking with publicly-traded funds. As I’ve noted before, there’s nothing wrong with a simple portfolio, and as this data shows, it’s likely to be the better way to go.
