The top hedge fund myths

Finbar Taggitt, the blogging hedge fund manager, points to a publicationCrestmont Research, written by Ed Easterling - “Hedge funds; Myths and Facts.”

The tone from Crestmont - which, according to its web blurb, says it “develops provocative insights on the financial markets and on the hedge fund industry” - is a tad tetchy.

“Never has an industry so extensively studied by “experts” produced such a surplus of myths,misunderstandings, and half-truths. Many of these myths could easily be clarified with a call or two to knowledgeable industry professionals. Too often, a seemingly logical statement that sounds-good-when-you-say-it-fast becomes accepted conventional wisdom despite the reams of evidence weighted against it.”

So here, according to Crestmont are the top myths about hedge funds:

1. Poor performance - “One of the most prevalent myths relates to the performance of hedge funds—that they generally don’t make enough returns. This myth has two elements: wrong conclusion and wrong benchmark.” When performance is compared to a portfolio of stocks and bonds, it argues, the funds have generated superior returns over time and have delivered this with lower risk. “When investors avoid the downside, they generally need a fraction of the upside to match market returns over time,” it adds.
2. Failure rate - “The conventional wisdom is that 10-20% of hedge funds fail each year—quite a blow-up risk for hedge fund investors.” In fact, “in two prior research studies, Crestmont Research found that twice as many hedge funds stop reporting after good performance compared to those that stop reporting after poor performance.”
3. Tax inefficient - “Almost universally, outsiders to the industry think that hedge funds are not tax efficient since they supposedly trade actively—all of the income must be either short-term gains or interest income.” Not so, it says - apart from anything else most hedge fund managers have significant personal investment in their funds and so have a personal interest in their fund’s tax efficiency.
4. Survivorship bias - “This myth implies that the hedge fund indexes reflect artificially high returns since they often do not include the poor performance of the funds that have moved to the graveyard.” See Myth 2. “Hedge fund returns actually may be higher than the returns reflected by the indexes. Why? Many of the best hedge funds don’t report their returns—they don’t need database marketing for new investors.”
5. High leverage - “Supposedly, hedge funds use high levels of leverage to amplify returns…the notion of high leverage appears to be the legacy of Long Term Capital Management. Most hedge funds employ modest or no leverage and relatively few use leverage to boost returns from general market exposure.”
6. Speculative - “Hedge funds are often believed to be speculative investors that take high risks to seek returns that are greater than the stock market..[but]…Superior hedge fund performance is driven by the skills of execution and risk management in markets that present mispricings and inefficiencies.”
7. Easy to start a fund - “Outsiders often quip: “Anyone can start a hedge fund…and they’re all doing it!”…..The one ingredient that most challenges the aspiring manager is capital. That provides a challenge that makes the Great Wall of China look like a country fence. To start a hedge fund, it requires commitments from a series of people willing to trust you with their money—people that have the ability and choice to invest with your start-up or alternatively to invest with a host of other established, successful funds.”
8. High fees - “This ‘penny-wise and pound-foolish’ myth asserts that the high fees at hedge funds prevent them from delivering satisfactory returns…….In summary, the fees are consistent with other alternative investments and the net returns from hedge funds more than cover the additional cost. Hedge funds provide investors with an enhanced return and risk profile compared to stocks and bonds as well as providing additional diversification.”
9. High-water mark closures - “If a hedge fund loses money, then supposedly the manager will just close the fund and start over to eliminate the need to make up losses before getting new performance fees…….This is one of the easiest to dispel, as it naïvely assumes that a poor performing hedge fund can either (a) return funds to disappointed investors and then dupe them into reinvesting into a new fund that is similar to what the investor had, or (b) find a set of completely new investors to launch again despite the recent failure and poor record. If we assume that hedge fund investors are completely irrational, then this myth might have a chance to be true—but in reality it is not accurate in the real world.”
10. Low transparency - Critics cry that hedge funds should be avoided because they are not required to disclosure their holdings and investors have no way of knowing what the fund is doing…This is rarely a complaint from existing investors in hedge funds….Most hedge funds provide a relatively high degree of access to relevant data and analyses about the fund and its holdings for their investors—if they didn’t or weren’t willing to provide sufficient transparency, the investor could make the choice to not invest or to withdraw.”
11. Source of return - “Most of the returns from hedge funds are driven by the trends in various financial markets; investors receive little skill for their excessive fees…..Memories must be short to have forgotten that hedge funds weren’t very correlated in the three years before 2003. While the stock market was falling during that period (and plunging in 2002), diversified portfolios of hedge funds were ringing the proverbial register for their investors.”
12. Long lock-up periods - “Another criticism relates to the provision in most hedge funds that requires investors to stay invested for a year or longer, so-called “lock-ups.” Some believers of this myth say that investors should demand an illiquidity premium, or avoid hedge funds entirely…This is rarely an issue for hedge fund investors, as they do not seek to invest for short periods and
    generally perform enough due diligence to commit for one year.”
13. Too many funds - “There are now more hedge funds than listed stocks. With so many funds, the critics claim that there must be limited opportunities for future profits….Yet, despite the fact that there were more hedge funds and a record level of capital in 2006 than ever before, hedge fund returns in 2006 were some of the best in years. It appears that the hedge fund industry may have quite a bit of capacity remaining.”
14. Hedge funds are not regulated - “Hedge funds often are said to be unregulated or lightly regulated. The perception is that hedge funds are cowboys taking advantage of the wild-west financial markets without a sheriff in town….Hedge funds are required to comply with every rule, regulation, and law that affects …virtually all investors in the public and private financial markets…When the topic of regulation arises in the hedge fund industry, managers are far from being cavalier about the existing and continually proposed regulatory requirements.”
15. Hedge funds are fast traders - “Hedge funds are believed to be active traders, constantly slinging stocks in and out of their portfolios…[but]…Turnover from hedge funds appears to be relatively similar to the turnover within mutual funds….In summary, hedge fund portfolio turnover annually according to Goldman Sachs appears to be near 50% to 70%. Mutual fund portfolio turnover according to ICI appears to be 60% to 120%. Could it be that mutual funds have higher turnover in their portfolios than hedge funds?”

Got all that? How wrong we can be.” When under-informed spectators view an unfamiliar process that operates with different principles and objectives, a natural result is myth and misunderstanding. The solution lies in enhanced collaboration between academia, industry, and the press,” the report concludes.