Hedge funds and the emperor’s clothing

A recent Bloomberg article questions the worth of hedge funds. Here are some quotes from the story: 

Hedge funds typically charge a management fee of 2 percent and keep 20 percent of any investment gains. That’s unjustified when managers just track market indexes, Read (Chief investment officer of the $225 billion California Public Employees Retirement System) said yesterday. The average hedge fund rose 13 percent last year, lagging behind the 13.6 percent increase of the Standard & Poor’s 500 Index, data compiled by Chicago-based Hedge Fund Research Inc.

“We can get average market risk very cheaply,” Read said in an interview at the Institutional Fund Management Conference in Geneva. “We hate paying a performance fee for something we can get very cheaply.”

Eight of every 10 hedge funds don’t provide the returns to justify the fees they charge, according to Harry Kat, a professor at the Cass Business School in London. After surveying as many as 2,500 hedge funds since 1995, he concluded that in 80 percent of cases the investors would have been better off putting their money elsewhere. “The bottom line is it’s like a charity where you give these people lots of money, they make a really good living out of it, and they provide you with returns that are substandard,” he said in an interview at the conference in Geneva.

“Hedge funds are like black boxes,” (Carol) Verkoeyen (works on allocation and research at Stichting Pensioenfonds ABP, the largest pension fund in Europe) said. “They charge these high fees and we don’t actually know if their returns are coming” from manager skill or market gains.

Lars Rohde, who oversees the 60 billion-euro ATP fund in Denmark, is refraining from investing in hedge funds until he’s convinced the performance is superior to other investments and that the fees are justified. “We have got to believe in the business model.” he said. “We are yet to be convinced.”

With a tidal wave of money having made made it’s way in to the hedge fund industry in recent years, it is little surprise that returns have converged with the market at large. The situation brings to mind the tale of ‘The Emperor’s New Clothing’, with the hedge funds playing the role of the swindlers who deceive the gullible emperor:

“Would his imperial majesty, if it please his grace, kindly remove his clothes.” said the swindlers. “Then we will fit you with the new ones, here in front of the large mirror.”

The emperor took off all his clothes, and the swindlers pretended to dress him, piece by piece, with the new ones that were to be fitted. They took hold of his waist and pretended to tie something about him. It was the train. Then the emperor turned and looked into the mirror.

“Goodness, they suit you well! What a wonderful fit!” they all said. “What a pattern! What colors! Such luxurious clothes!”

“The canopy to be carried above your majesty awaits outside,” said the grandmaster of ceremonies.

“Yes, I am ready!” said the emperor. “Don’t they fit well?” He turned once again toward the mirror, because it had to appear as though he were admiring himself in all his glory.

The chamberlains who were to carry the train held their hands just above the floor as if they were picking up the train. As they walked they pretended to hold the train high, for they could not let anyone notice that they could see nothing.

The emperor walked beneath the beautiful canopy in the procession, and all the people in the street and in their windows said, “Goodness, the emperor’s new clothes are incomparable! What a beautiful train on his jacket. What a perfect fit!” No one wanted it to be noticed that he could see nothing, for then it would be said that he was unfit for his position or that he was stupid. None of the emperor’s clothes had ever before received such praise.

“But he doesn’t have anything on!” said a small child.

“Good Lord, let us hear the voice of an innocent child!” said the father, and whispered to another what the child had said.

“A small child said that he doesn’t have anything on!”

Finally everyone was saying, “He doesn’t have anything on!”

The emperor shuddered, for he knew that they were right, but he thought, “The procession must go on!” He carried himself even more proudly, and the chamberlains walked along behind carrying the train that wasn’t there.

This is from the Hans Christian Andersen version. For other versions of the tale click here.

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