Hedge Fund Underperformance
An article the New Yorker has a profile of a Dutch academic who has researched hedge fund returns and found that after the annual management fee and performance fees, the returns of hedge funds don't provide market beating returns. I can't say that I am surprised by these results. Most mutual funds don't beat the market so why would hedge funds be any different, especially after the "2% and 20%" fee structure. Fund of funds have an additional layer of fees and their performance is even worse. Another shocking discovery.

The interesting part of the profile of Harry Kat is that he has developed a software program, FundCreator, that will mimic the trades of any hedge fund with a track record. He sells this for a fee of .33% of assets and no performance fee. The software owner has to make the trades and the trading costs are additional. Even if this program allows an institution to have average returns, the overall net gain would put the institution ahead because its fees will be so much lower than other hedge funds.

One part of the article worth noting is the section on hedge fund risk:

When Kat examined the databases, he noticed that in most years hedge funds outperformed the Dow and the S. & P. 500; they appeared to have produced alpha. But the figures in the databases don’t take into account the unusual risks that hedge funds take. Many funds use borrowed money to leverage their investments; they short stocks; and they speculate on the price of volatile commodities, such as gold and coffee.

Another section follows:

In a study published in the June, 2003, issue of the Journal of Financial and Quantitative Analysis, he and a co-author, Gaurav Amin, an analyst at Schroder Investment Management, a British financial firm, compared the fee-adjusted returns of seventy-seven hedge funds between 1990 and 2000 with the returns generated by a market benchmark that had a similar risk profile. Seventy-two of the funds—more than ninety per cent—failed to outperform their benchmarks.

So 90% of hedge funds under perform. I find this surprising, too.