Hedge Funds Remain a Great Business

In January 2012, I published The Hedge Fund Mirage; The Illusion of Big Money and Why It's Too Good to Be True. Although hedge funds have long been associated with fabulous wealth, a little-appreciated fact was that substantially all the profits generated by hedge funds had been eaten up in fees paid to the hedge fund managers themselves. Funds of hedge funds and consultants had taken the rest, with the result that, while hedge funds had been fantastically profitable investments, those profits had not made their way through to the clients.

The book caused quite a stir within the hedge fund industry. All I had done was consider returns from the standpoint of ALL the investors. Conventionally, historic returns on most types of investment are calculated assuming a single commitment of cash by the client at the beginning of the period. By this measure, hedge funds indeed looked very good. Starting back in the 1990s depending on which hedge fund index you use, returns are quite decent, at 6% to 7%. And it's true, hedge funds used to be very attractive. In the late 1990s and through 2000 to 2002 when stocks were collapsing along with the bursting of the dot.com bubble, hedge funds did what they were supposed to do. They hedged, preserved investor capital, and earned a well-deserved reputation for delivering good, uncorrelated returns. The investors at that time did very well. There just weren't that many investors.

This success drew substantial amounts of new capital from institutions eager to find some way to diversify their traditional mix of equities and fixed income. It was a completely understandable decision, one that at JPMorgan at the time we supported. In fact, in 2001, anticipating just such a flood of institutional capital into hedge funds we set up a hedge fund seeding business, the JPMorgan Incubator Funds. Since many of the best hedge fund managers were already so highly sought after that they were turning away potential clients, we felt that the best new hedge funds would be highly sought after. The Incubator Funds' investment model was to try and identify tomorrow's top hedge fund managers today, before they were overwhelmed with capital. By using JPMorgan's vast network of financial market contacts, we were able to identify talented managers early and, at least as important, reject those whose background and pedigree were inadequate.

Perhaps most importantly, we were able to negotiate a share of the manager's business. Although we wanted hedge funds that would generate good returns, we were most interested in sharing in the lucrative fees that they charge, the now ubiquitous “2 & 20” (2% management fee and 20% of the profits, annually). We recognized that the business of hedge funds was likely to be a far better investment than simply being a hedge fund client. As subsequent developments showed, that turned out to be far truer than we could have imagined.

As money flowed into the hedge fund industry, generating attractive returns became more and more challenging. A swelling pool of assets gradually exhausted most of the arbitrage-like, uncorrelated return opportunities out there. Over time, hedge funds began taking more bets on the overall direction of the market, magnified by leverage. They became more reliant on their ability to quickly adjust their risk profile when markets moved against them. An industry that had earned its positive reputation by exploiting market inefficiencies with carefully designed, tightly controlled hedged strategies drifted toward more prosaic bets. As the years went by, more and more hedge fund portfolios were exposed to directional moves in equity and credit markets. This shift in investment styles, combined with the influx of money, led to the damning result that in the 2008 financial crisis the losses incurred by hedge funds wiped out all of the cumulative profits they had ever earned for their investors.

Although some tried to explain away this disastrous outcome as a completely unforeseeable consequence of market collapse that few expected, the fact is, hedge funds were found wanting at precisely the moment when their uncorrelated returns would have been most important to investors. During the 2000 to 2002 technology-driven bear market, hedge funds had delivered as promised. The contrast between that period and 2008 couldn't have been more stark. Clearly, something had changed.

In fact, the fundamental error that's still being made by today's hedge fund investors is that they never consider the natural limits to size facing the industry. It's quite an amazing oversight. There's lots of academic research to show that small hedge funds outperform big ones. Their small size allows them to get in and out of trades nimbly as well as to exploit minor inefficiencies that wouldn't be material for larger funds. Hedge fund investors generally agree that small hedge funds outperform big ones. Finding small hedge funds is expensive though, so it's not a practical approach for institutions with billions of dollars to allocate. It's also not an approach advocated by the consultants that advise these institutional clients. If your business is to recommend individual hedge fund investments to your pension fund clients, it's a far more efficient business model to research big hedge funds because they will accept larger investments, and as a consultant you can make the same recommendation to multiple clients, which cuts your own costs of research.

While investors recognize that small hedge funds are better than big ones, they also know that most big hedge funds they look at were themselves better when they were smaller. That's how they became big, by generating good returns while small. And yet, today's hedge fund investors and their advisors fail to make the third and obvious step, and realize that a small hedge fund industry was better than today's big one. The results speak for themselves, and in fact, if I was to write The Hedge Fund Mirage today, the results would be more negative. As I often say, I predicted in 2012 that future hedge fund investment results would be disappointing, and the industry has cooperated ever since in providing further empirical support!

Industry Reaction to the Dismal Truth

In early 2012 when The Hedge Fund Mirage was published, its controversial stance quickly caught the attention of the financial media. Everybody had become so used to seeing lists of unbelievably huge paydays for hedge fund managers that it seemed beyond question that the clients must be doing well, too. The revelation that this wasn't the case was itself newsworthy. The media interest didn't surprise me; I had thought it was a huge story myself as I was writing it. And as I point out in the book, I was by no means the first person to identify the gaping contrast between actual and perceived investment results. An academic paper by Ilya Dichev from Emory University and Gwen Yu of Yale had arrived at a similar conclusion. Not enough investors read their research (academic papers are not to everybody's taste). Their work inspired me to examine why this was the case and to present it in a form that could be more readily digested by the investors whom I was hoping to inform.

What did surprise me was the reaction of the hedge fund industry itself. Hedge fund managers are some of the smartest people you'll meet in the investing world. Big money attracts the most talent in any field. The vast majority of the people I've known since I first began investing in hedge funds in the early 1990s are reasonably intelligent. I publicly criticized an entire sector of finance, even an entire asset class (some people assert that hedge funds are not an asset class since they invest in other assets themselves; their precise definition is not important). Many people could have been understandably quite defensive as I bashed their means of earning a livelihood to the gleeful accompaniment of the mainstream financial press. The Wall Street Journal, the Financial Times, and The Economist, as well as many other print and cable TV outlets, interviewed me and provided balanced but favorable coverage.

To the eternal credit of many thoughtful hedge fund professionals, rather than reacting defensively or trying to ignore me, they engaged me. I was invited to speak at numerous hedge fund conferences. Some may have disagreed with me, or wished that what I was pointing out wasn't true, but they nonetheless invited me to present my ideas.

Even more surprising was the reaction of many hedge fund managers. I was frequently contacted by people running successful funds, and invariably the dialogue was along the lines that they loved my book, and that of course there was enormous mediocrity throughout the hedge fund world. Though not in their fund, of course!

This made perfect sense. Hedge fund managers are smart. They fully recognize the challenges of size in investing: “Size is the enemy of performance.” Successful hedge fund managers often cap the size of their funds for this reason, because as they get richer their own investment in their fund grows and they become more concerned that excess capital will dilute the returns on their own money. You'll never hear a hedge fund manager recommend a diversified portfolio of hedge funds as a thoughtful approach. That's because they understand its limitations. They recommend their own hedge fund and maybe a handful of others where they know the manager personally. The smartest people in the industry already get it.

In fact, in the months following the book's release we struggled to find much of a negative response. I had simply shouted that the emperor had no clothes, and it turned out a great many people had quietly felt all along that something was very wrong. A group in London called the Alternative Investment Managers Association (AIMA), whose mission is to promote the use of hedge funds, did fortunately step up and gamely attempt a rebuttal. Since their job is to persuade investors of the value in hedge funds, they were only going to come out on one side of the debate. They put out a couple of write-ups that didn't directly address the issues and didn't convince many people. One academic referred to my book as, “…baby hedge fund analysis 101 at best,” displaying arrogance from the safety of an ivory tower unburdened by the need to make actual investment decisions.

I watched in the blogosphere for reaction to the criticism. Felix Salmon is an erudite, well-informed financial writer for Reuters and others. Felix read my book and AIMA's response. In a truly memorable put-down of their PR effort, Felix wrote that AIMA had, “…convinced me of the deep truth of Lack's book in a way that the book itself never could” (Salmon 2012). The inadequacy of AIMA's response had provided further support.

More recently, AIMA partnered with the Chartered Alternative Investment Analyst (CAIA) Association and commissioned Hedge Fund Research (HFR) to figure out how hedge fund investors had done. All three groups, of course, make a living from a big hedge fund industry, so unsurprisingly, the HFR study commissioned by AIMA found hedge fund investors had made an implausible $1.5 trillion over the past 10 years (AIMA 2015). Their methodology wasn't disclosed, but somehow HFR was able to show that hedge fund investors had made, for example, $20.1 billion in 2011 even though HFR's preferred index, the HFRI Fund Weighted Composite Index, which represents the broadest measure of the industry, was down –5.25% that year. If you torture the data sufficiently, it will tell you whatever you want to hear. People have moved on, though. Few journalists picked up the story, most likely because they've already concluded AIMA is just a relentless sales organization with little objectivity.

Why Hedge Funds Are Still Growing

Over three years since the book's publication, subsequent hedge fund industry results continue to be inadequate at best if not downright disappointing. Yet investor capital has continued to flow into hedge funds, which have grown from around $2 trillion in assets under management to perhaps $2.5 trillion today. Apart from the fact that it shows not everybody who read the book was convinced, it also suggests that the returns I find so mediocre are in fact quite acceptable to at least those investors making the allocations. Perhaps the strongest riposte hedge fund apologists can mount is to point to the voting of clients with their money. They're all consenting adults, and capitalism's allocation of resources to products and services based on countless independent decisions is the best way we know of to let the best rise to the benefit of all.

The obvious response to this is that the history of investing is littered with episodes of capital flowing too readily to areas that ultimately prove poorly considered. It's not that every successful investment idea eventually blows itself up, but every one that does blow up was preceded by a thoughtless scamper to join the crowd. Early, smart money is followed by the less astute. So we'll put financial success for hedge fund promoters in the category of dubious support for the notion that a bigger hedge fund industry is better.

In the early days of hedge funds the investors were generally wealthy individuals, “high net worth” investors acting either through the private banks that covered them or on their own. Someone once asked me if I was saying that these generally self-made wealthy entrepreneurs were the dumb money. In fact, it's quite the contrary. Today's hedge fund investors are far more likely to be institutions especially US public pension funds investing the retirement savings of teachers, firefighters and other public sector workers. Wealthy individuals are far less significant investors today. In many cases, they represent the smart money, in that they enjoyed the successes of hedge funds 15 or so years ago.

This is good news. The point of this book is that too often, individual investors receive poor, expensively delivered advice. We hope that all investors big and small will find that this book helps them avoid some of the more egregious products we've written about. That individual investors are less committed to hedge funds reflects a more discerning approach.

So the case for hedge fund vindication relies on the investor acceptance represented by “sophisticated institutional investors” with all their research capabilities deploying some of their capital as they are into hedge funds. I often smile when I hear that phrase sophisticated institutional investors. It's usually used by service providers seeking to impose an imprimatur of quality on their own business by virtue of their clientele. Of course, many institutional investors are sophisticated. They have the resources to hire investment professionals to advise them on their portfolios, and many do. But just as not all hedge funds are bad, not all institutional investors are sophisticated. In fact, some of the least sophisticated are the public pension plans plowing their money into hedge funds.

The Trustee Leadership Forum is a group affiliated with Harvard University that brings together the trustees of public plans with the objective of sharing best practices and learning from one another. I once had the opportunity to present the findings of The Hedge Fund Mirage to one of their events, so I traveled up to Cambridge, Massachusetts, to Harvard University.

The speaker before me was Diane Mulcahy from the Kauffman Foundation in Kansas City, Missouri. I knew Diane because she was co-author of a fascinating research paper titled “We Have Met the Enemy and It Is Us.” It arrives at similar conclusions about venture capital (vc) investing to the ones that I reached on hedge funds, in that smaller vc funds are better than big, that the 1990s was a far better time to be invested than after 2002, and that fees had consumed far too much of the profits. I dubbed it “The Venture Capital Mirage.”

When it was published I had chatted with Diane about their findings, which were largely drawn from the Kauffman Foundation's own investing experience. It remains an outstanding effort to inform vc investors, based on the experience of one very definitely sophisticated institutional investor.

Diane was giving her presentation and we were all watching with great interest as she went through the analysis they had performed on the Foundation's overall investment results. Examining private equity returns can be complicated, and Diane was doing a great job of walking her audience through the exercise with charts and figures. It wasn't a presentation you'd expect a high school student to readily grasp but was certainly appropriate for a roomful of public pension trustees, stewards of some of the largest pools of investment capital in the United States.

Midway through Diane's presentation, an audience member posed the most basic question. What did Diane mean by the use of the word median? For those of you for whom middle-school math is a distant memory, the median is the point at which exactly half the observations you're measuring are higher and half lower. It's not the mean but is often close to it. For someone in investing, you'd no sooner feel the need to explain what you mean by median than you would tell them who is the president of the United States.

Diane was only momentarily surprised by the question before she quickly regained her composure and politely explained the term. I was stunned. Not just that the questioner didn't know the answer, but also because he wasn't at all embarrassed to ask in front of his peers. As the day wore on and I spoke to more people, it dawned on me why this was the case. His peers weren't investment professionals at all. At lunch I sat with a retired firefighter. At another table was a retired steelworker. These were some of the people who were pension fund trustees. They'd spent their careers working in fields as far from investing as it's possible to be, and were there to represent the interests of their former colleagues who no doubt trusted them to look after their interests. My overwhelming impression that day was of thoroughly conscientious people working very hard to improve their understanding so as to do a better job at managing retirement savings.

In fact, investing doesn't have to be that complicated. It's not a bad test to say that if it can't be explained to a retired firefighter (or teacher, nurse and so on) then maybe it shouldn't be recommended. Call it the Public Sector Worker Test.

Some Accounting Rules Are Dumb

Now let's return to the growth in the hedge fund industry and examine why the increase in clients shouldn't be interpreted as a popular vindication of value to the typical investor. While the early investors in hedge funds in the 1990s were largely high net worth individuals, over the past decade or so institutions have become a far more significant source of hedge fund capital. Perhaps the most important among these have been the public pension plans, charged with managing the retirement of America's public sector workers such as teachers, firefighters, and so on.

Public pension plans use some pretty strange accounting. Since investing for retirement entails providing income for beneficiaries several decades into the future, pension funds have very long investment horizons. In calculating whether they have enough assets today to meet tomorrow's obligations, they estimate all of the cumulative payments they expect to make over the likely lifetimes of their beneficiaries. These future payments are then converted into today's money by discounting them using an appropriate discount rate. It's the time value of money. Commonly, corporate pension funds will use the rate on bonds of similar maturity to the timing of the pension's obligations. The lower the discount rate, the higher the “present value” of those obligations and consequently the more assets are required in order to show that the pension obligations are fully funded. A low discount rate is more conservative than a high one, since the assets the pension fund holds need to be invested profitably so they grow sufficiently.

Many public pension funds in the United States are underfunded, which is to say the assets they own are unlikely to be sufficient to meet future retiree obligations. It's a steadily growing problem, and while it may never lead to a crisis, it will create a growing tax burden for the next generation of taxpayers as state governments are forced to close their pension deficits by raising taxes. It is an unfortunate legacy of the baby boomer generation that it has consistently voted for political choices that pushed such obligations into the future, something I wrote about in my book Bonds Are Not Forever; The Crisis Facing Fixed Income Investors.

Using bond yields as the discount rate to calculate the present value of future pension obligations is a sensible approach, and this is what most pension funds do. However, public pension funds follow a different set of accounting rules, and in an especially bizarre departure from private practice they use their expected return on assets to discount their liabilities.

To show how odd this is, you need only consider how shifting their asset mix can have a dramatic effect on their obligations. A pension fund expects to earn a long-term return on its assets based on the likely return for each asset class and the proportion of its assets in that asset. For example, suppose it invested half its money in stocks with an expected return of 7% and the other half in bonds with an expected return of 3%.

Clearly shifting the mix of stocks and bonds will alter the expected return. Add more risky stocks and the expected return will rise, as will the risk of the resulting portfolio.

What's uniquely odd about public pension plans is that they also use this expected return as the discount rate for their liabilities. It's a perverse treatment, because it means that changing the mix of assets alters the present value of their obligations, although their actual obligations haven't changed. So a more risky mix of assets, through the higher discount rate it produces, lowers what they owe future retirees and therefore improves their funded position.

The Economist magazine, my personal favorite weekly publication, captured the problem with this approach quite elegantly in an article titled “Money to Burn” (The Economist 2013). The article noted that, just as increasing the share of your portfolio invested in higher returning, risky assets can translate into a lower obligation, so can removing low yielding assets. Cash, which earns close to 0%, is a drag on any portfolio's returns. The article colorfully notes that if a pension fund held cash and simply got rid of it (i.e., burned it as in the title of the article), this would drive up the expected return on assets of what remained and therefore drive down the present value of the liabilities.

In this way, the pension fund could appear to be better off through having a reduced obligation, even while the assets with which it planned to meet those obligations were now smaller because they'd burned the cash. It may sound like an absurd example, but it highlights that driving the expected investment return higher by increasing the allocation to higher returning assets does the same thing. So a more risky pension fund can appear to be in better shape than a less risky one.

Because an allocation to hedge funds carries with it that hoped-for 7% return (this seems to be what most hedge fund investors and their consultants expect of their hedge fund investments over the long run), public pension funds are incented to add hedge funds (burning cash might achieve the same result from an accounting standpoint but has unattractive optics).

This is what has happened. Hedge funds with their 7% return potential can appear very attractive to public pension funds grappling with insufficient assets to meet retiree obligations. They can serve to delay the inevitable day of reckoning with its politically unattractive tax hikes or spending cuts (or both) to make the numbers add up.

The problem is, no one is pointing this out. The consultants that advise public pension plans are conflicted because recommending hedge funds pays well, so there's little incentive to do anything else. Moreover, the consultants themselves rarely demonstrate a track record of profitable recommendations. One study in 2013 found that investment consultants were “worthless” (Sorkin 2013).

Pension fund trustees are caught in a tough bind. They generally rely on consultants because the requirements of the Employee Retirement Income Security Act of 1974 (ERISA), which regulates pensions, places a heavy burden on trustees. ERISA includes civil and criminal provisions for those who fail to oversee pension fund assets in a way that's in the best interests of the beneficiaries, so it's little wonder that they use consultants.

Politics Drives Asset Flows

The other problem facing public pensions is that when they're underfunded, there's not much of a political consequence. A shortfall between the assets held by a pension fund and its obligations ultimately has to be made up by increased contributions. It's a brave politician who opts to raise taxes or cut services today so as to fully fund a pension, versus leaving the problem to grow for elected leaders to deal with 10 or 15 years later. Most voters will opt for policies that defer topping up pensions. It may be criticized as poor public policy, but it's the democratic process at work. New Jersey is just one example. In 2014, Governor Chris Christie slashed pension contributions (Magyar 2014) by $2.4 billion to meet a budget shortfall. Unions representing the beneficiaries challenged the move, but Christie evidently calculated that few voters would be that bothered. Short of ironclad legal requirements that such pension obligations be fully funded, political leaders responding to the desires of voters will kick the can down the road.

This was brought home to me quite memorably by a representative of the Los Angeles County Employees Retirement Association (LACERA). During my presentation, she explained the actual dilemma they all faced. Noting my recommendation to drop hedge funds from their portfolio, she walked through the likely consequences. The expected return on their assets would fall, since hedge funds with a 7% return target was higher than their other holdings. No matter that 7% is an unrealistic figure to expect of hedge funds; it's provided by the consultants and therefore independent of the trustees even if based on dubious assumptions.

The lower expected return on the pension assets would then feed through to a lower discount rate on its liabilities as described above, which would then increase the underfunded position of the pension fund. “At which point, those Republicans will point to the gap and demand that we cut benefits,” she continued. I never get into the politics of the issues, but I sympathized with her plight. Because of the political process that provides funding for public pension plans and their curious accounting, many people with responsibility for tomorrow's retirees unquestioningly cling to the fantasy of the kinds of hedge fund returns that we haven't seen for over 10 years. Those who believe that the growth in hedge fund assets represents vindication for the asset class are not thinking very deeply about the process through which such decisions are made.

Some public pension plans are responding to the continued disappointing returns. The California Public Sector Retirement System (CalPERS) is often regarded as a thought leader among other pension funds, and with over $300 billion in assets it is one of the largest institutional investors in the world. In September 2014 it announced (CalPERS 2014) the elimination of hedge funds from its portfolio, concluding that the cost of investing wasn't justified by the returns. One interesting disclosure was that in the most recent fiscal year through June 2014, CalPERS had paid $135 million in fees on a $4 billion portfolio that earned 7.1%. The approximately $280 million in investment returns ($4 billion × 7.1%) means that for every $2 in returns, it paid away a third dollar in fees. Of the gross returns (i.e., before fees), two-thirds went to CalPERS and one-third to the hedge fund managers. When you consider that it's possible to invest in equity index funds for less than 0.1%, this division of investment profits between the provider of capital and the managers must have appeared as absurd to CalPERS as it does to everyone else.

One seldom-acknowledged fact about hedge fund returns is that a simple 60/40 portfolio of stocks and bonds has beaten hedge funds since 2002. Prior to that, hedge funds had actually done a pretty good job, often justifying their hefty fees and the faith investors had in them. Few knew at the time that the best years of performance were already in the past. The plain-vanilla stocks and bonds portfolio hasn't just beaten hedge funds since 2002. It's done so every single year since then. Some years stocks have been strong and sometimes bonds, but the combination has relentlessly left behind the expensive and by now bloated asset class.

The response of some of the industry's proponents can make you smile. I'm often asked to give a presentation on my views on hedge funds. As I often note, although The Hedge Fund Mirage was published in 2012, hedge funds have co-operated by continuing to generate mediocre returns at great expense, which is causing more and more people to question the standard recommendation of a diversified portfolio of hedge funds.

Hedge funds used to be referred to as absolute return vehicles. It sounded very solid, portraying the talented navigation of a portfolio through the unpredictable waters of market volatility with the assurance that the eventual result would be a positive (i.e., absolute) return no matter what the prevailing conditions. Few use the term any more, since 2008 demonstrated so convincingly that almost nothing apart from developed market sovereign debt was immune to the hurricane unleashed by mass deleveraging. The Absolute Return moniker is long forgotten, although a monthly publication, AR Magazine, retains the title it drew from its coverage subject in a quaint reminder of what used to be.

Absolute returns were dropped in favor of generating attractive relative returns, which also seemed like a solid, reliable objective. However, the history since 2002 increasingly demonstrates that the relative returns being generated are relatively poor, at least compared with the stocks/bonds portfolio as described above. So the goalposts shifted again, to one of generating uncorrelated returns. This also appears like pretty safe ground. Although in 2008 hedge funds were unfortunately too highly correlated with everything else as they lost 23%, they do seem to be reliably uncorrelated and worse than other assets.

Too Much Capital

The pressure on returns doesn't just come from the weight of assets under management, which has the effect of creating too much competition for the interesting opportunities that are out there. CalPERS found size to be a constraint in determining to end their hedge fund portfolio. An additional problem is the institutionalization of the business. As with other asset classes, big investors seek diversified portfolios following one of the core precepts of the capital asset pricing model (CAPM), which is that diversification is always a good thing.

However, for diversification to work, the risks of your individual holdings need to behave somewhat predictably. Since part of their original selection was based on their being uncorrelated with one another, it's important that they retain that feature going forward. Today's hedge fund investors are far more focused on the potential for a hedge fund to experience style drift, which simply means the manager begins to invest in a way that's different from the past.

It's easy to see why this might be a problem. If a portfolio of hedge funds that were previously uncorrelated with one another all begin to drift toward a new investment style or set of opportunities that they all deem attractive, they will no longer possess the diversification that led to their combination in the same portfolio. This is a potentially huge problem for the investor, and is one reason why the potential for style drift is carefully monitored.

However, an unintended consequence can be that by limiting a manager's freedom to roam where he sees the best opportunities, it also shields the investor from an important element of the manager's overall skill. Many of the best hedge fund managers back in the Golden Days of hedge funds (pre-2002) did just this, often to the benefit of their clients. The wealthy individuals who were the typical clients in those days held fewer hedge funds than today's institutions. They knew little and cared less about style drift. They just wanted their managers to make money. The constraints today's institutions seek to place on hedge fund managers reduce both the risk and the return potential.

I once wrote a post for my blog titled “The Dumbest Idea in Finance,” which is how I described the conventional, broadly diversified portfolio of hedge funds that is so often the way institutions approach them. It was, of course, an incendiary title, but it was backed up with an interesting twist on conventional thinking.

Financial theory in the form of CAPM holds that a diversified portfolio is a good thing. In CAPM-speak, there is no excess return to idiosyncratic risk. What this means is that any time you spend selecting individual investments is not going to provide you any improved risk-adjusted return over and above what you could earn holding a highly diversified portfolio. It means that for investors in equities, for example, they should just hold an index fund rather than waste time on individual stocks. Put another way, you don't need any insight in security selection to be invested in equities.

Although the entire universe of active equity managers (which includes your author), by their very existence disagrees with this conclusion from CAPM, it's certainly also true that holding index funds is a perfectly legitimate way to be invested in stocks.

A crucial premise here is that over the long run, stocks have a positive excess return, which is to say they do better than the risk-free rate. Although equities can obviously have bad years and even a bad decade, the notion that they have a positive long-term return is not a contentious idea. Hedge funds are different. As I showed in The Hedge Fund Mirage, Treasury bills would have been a better bet for investors in aggregate. It's not at all clear that in the future hedge funds will outperform the risk-free rate. In such a case, the conventional thinking about diversification breaks down. In fact, if you're investing in an asset class with poor or negative future returns, you clearly need to be good at picking individual investments. For the hedge fund investor, this means you have to have skill at manager selection.

This is not just nice to have, it's so critical that if for some reason you're not good at selecting hedge fund managers, then you shouldn't bother investing at all. By contrast, equity investors who are no good at picking stocks can still invest in equities by using index funds. Hedge fund investors invariably believe they possess insight about picking hedge funds. Of course they can't all be good at it, but some are. For those that are good, diversification will only serve to hurt them, as the more diversified their portfolio of hedge funds, the more it will be drawn toward the mediocrity of the average return. Since the average has been poor and is likely to stay that way, investing broadly so as to dampen the impact of any one manager on performance is really counterintuitive. Therefore, diversification is really useful to hedge fund investors who are not good at manager selection. For them, the average return is better than they'll get relying on their insight. Conversely, good insight on manager selection argues that you shouldn't dilute it.

Therefore, a focus on fewer hedge fund investments where you have the highest conviction is more likely to be rewarding for the investor with manager selection skill. A highly diversified hedge fund portfolio is the sign of someone who knows he or she is not that good at picking them, and strives to achieve the mediocre average return because it'll likely be better than would be achieved with fewer managers.

Fewer hedge funds means a more concentrated portfolio, which naturally means you should allocate less to hedge funds. This isn't an attractive proposition to pension funds relying on hedge funds to help cover their underfunded retiree obligations, nor to the consultants who earn fees advising them on how to build their portfolio.

Nonetheless, this is what happens when you apply the world of CAPM to an asset class that wasn't contemplated in its design. Of course, few hedge fund investors would concede to the logic outlined above. They would claim that adding diversification simply provides greater exposure to the selection skill they already have. Nonetheless, hedge fund returns continue to be poor in aggregate.

Hedge fund managers are often held to be the smartest people in finance. Ted Seides, co-founder of Protégé Partners, a fund of hedge funds, once said, “The best and brightest spend their time where the compensation is best, and today in the public markets, that's clearly in the hedge fund universe” (Seides 2014). The irony is that I don't think a hedge fund manager has ever publicly recommended investing in hedge funds the way Seides and others do for their clients, through large, diversified portfolios. Just because the smartest people run hedge funds doesn't mean you should want to be their client.

An amusing exchange took place in late 2014 involving Seides and other commentators. Perhaps feeling that the recent decision by California's largest public pension plan to redeem its hedge fund investments demanded a public defense of hedge funds, Seides wrote a blog post suggesting the possibility of poor timing by the California fund's managers. The subsequent responses quickly poured cold water on Seides's position. Such is the contempt with which many nowadays hold hedge funds, given their continued poor performance that humor at poor Seides's expense soon followed.

In 2008, Warren Buffett famously made a bet with Ted Seides that the S&P 500 would outperform any fund of hedge funds over the next 10 years. It is a bet that Protégé will probably wish had never been made. Certainly, by late 2014 Buffett was looking like a clear winner, and Seides's blog posting wound up drawing reminders of his rash decision to take on Omaha's Oracle. Even though the bet's time period included all of 2008 with a 37% loss in the S&P 500, hedge funds have still been a clear loser. Piling on the misery, one reader compared the performance of Protégé's own fund of funds with the S&P 500. Five years earlier, commentators may not have been so quick to knock hedge funds, but more recent history—perhaps aided in some modest way by The Hedge Fund Mirage—have provided the tools for more robust and pointed criticism.

For Once, the Retail Investor Wasn't Duped

Unusually, this is one of those rare cases where the unsophisticated retail investor has not been the victim of overpriced investments with high fees. Because hedge funds are generally offered via unregistered securities, in the United States and many other countries this has restricted their availability to high-net-worth investors and institutions, both of whom are regarded as smart enough to discern a good opportunity from a poor one. Somebody once asked me during one of my presentations if I was implying that high-net-worth investors were stupid to be invested in hedge funds. It raised an interesting point. To generalize, wealthy individuals were a far more important source of capital to hedge funds before 2002. Since then, they have shrunk as a percentage, and the unexpected imposition in 2008 of so many impediments to redemptions hastened their departure.

I'm always careful to point out that there are great hedge funds and happy clients. Some of the most talented investors around run hedge funds, because that's where the fees are highest and the most money can be made. That will always be the way. And there are happy hedge fund clients, too. Often, they only hold a handful of hedge funds, and rather than pursuing a diversified portfolio of managers, they've simply picked a small selection of talented people to manage their money. Those that are happiest with hedge funds aren't relying on them the way many institutions do to reshape their overall investment portfolios. A slim reliance on hedge funds with an opportunistic approach when circumstances permit is a more reliable way to achieve a successful outcome.

The high-net-worth individual investors of the past were the smart money. When private banks were the dominant allocators to hedge funds, they guided their rich clients to managers they liked, and returns were good. It was the arrival of institutions to hedge fund investing that coincided with the degradation of returns, which shouldn't have been a surprise because hedge funds have limited capacity to generate attractive results. It's fair to say that wealthy individual investors enjoyed the best years of hedge funds, and rather than being stupid were quite astute in their timing. I know quite a few individuals who were very successful with their hedge fund investments. Moreover, they often held only two or three such investments, illustrating the point above that sometimes less is more.

I don't believe any of the investors including today's can be characterized as stupid. Public pension plans are simply responding to the odd accounting described above and the politics of deferring financial pain as long as possible.

Today's hedge fund investors need to return to the approach that worked so well in the 1990s when the industry was less than a quarter of its present size. First of all, any analysis of future returns that fails to consider the size of the opportunity set is fundamentally flawed. This is the most obvious error being made by so many consultants and their clients today. They are extrapolating past returns into the future and creating an implausible vision of unlimited market inefficiency waiting to be exploited to their benefit. Diminishing returns to size are a common problem. Failure to contemplate the limits to size of an investing style or the industry overall has been a major mistake. It's really quite naïve. Recommending a substantial hedge fund allocation today either reflects a profound misunderstanding of how financial markets work, or a cynical appreciation of the quirky way public pension accounting renders hedge funds a plausible solution to a funding shortfall. Either way, we can look back on the consulting advice provided over the past several years to the trustees of billions of dollars of public sector retirees and question whose interests were really being served. Hedge fund research has paid well.

Since $2 trillion to $2.5 trillion has been shown to be an excessively large amount of capital for hedge funds in aggregate, the well-advised institutional investor should first rein in their expectations in terms of how much money they can profitably invest. Broad exposure (in some cases up to 20% of assets or more) to an overcapitalized industry is hardly likely to generate a satisfactory outcome. Instead, they should create a much smaller pool of 2% to 4% of their portfolio to be invested opportunistically in a few areas that are lightly trafficked and where additional capacity remains. This won't be easy—by definition, finding little-known investment areas requires some digging around. But this is where the investor is more likely to find market inefficiencies to exploit. They're also more likely to find managers with the time to sit down and really explain what they're doing.

Obscure investment opportunities are likely to be uncorrelated with the rest of one's portfolio, and may also provide interesting knowledge that can be applied in more size or elsewhere across certain core investments. It's quite likely the hedge fund exploiting a little-known area will identify related opportunities. It can be worth giving smart people a chance to do something a little different, so the investor ought to allow some flexibility of mandate here. Today's institutionally driven hedge funds with their carefully focused strategies that avoid style drift and multiple layers of risk are designed to be expensive but unexciting. The best hedge funds are risky, and risk mitigation comes through a thorough understanding of the risks being taken.

Small allocations to obscure strategies are likely to work best for hedge fund investors. Big allocations to well-known hedge funds work best for consultants. Consequently, the latter will continue to trump the former until continued mediocre results delivered at great expense provoke the ultimate clients into demanding a different approach.

Hedge funds continue to represent a disproportionate number of investment frauds. As I noted in The Hedge Fund Mirage, there is even a book devoted to them called The Hedge Fund Fraud Casebook (Wiley, 2010) by Bruce Johnson. It's not that hedge fund professionals are dishonest—even though I'm a critic of the broad industry, I don't believe the people in it are any less honest than other areas of finance. It's just that if you're looking to commit fraud, a hedge fund is the perfect vehicle. The securities are unregistered and the manager may also not be required to be registered with any state agency or the SEC. Creating a fictitious list of holdings in public companies is less likely to cause suspicion than, for example, claiming to own a building or private company that might not exist.

Madoff represents the biggest and most stunning fraud in history. Some quibble and say he wasn't running a hedge fund—it's a meaningless distinction because the clients believed they were investing in a hedge fund. Harry Markopoulos is known as the Madoff Whistleblower because of his gripping book, No One Would Listen (Wiley, 2011). When we were seeding hedge funds at JPMorgan, we met with Fairfield Greenwich Group (FGC), which was one of Madoff's feeder funds, channeling clients into the abyss. They described a structure that sounded very much as if the hedge fund was able to front-run orders received by Madoff's brokerage business. The salespeople at FGC didn't come right out and say this, but they described a “close working relationship” between Madoff's two operations that could be interpreted as such. We didn't have any subsequent meetings with FGC because the setup didn't sound right.

Later, I had the opportunity to meet Harry Markopoulos and we exchanged books, each signing a copy of what we'd authored for the other. In the copy of his book that Harry signed for me, his memorable inscription was, “Assume Fraud Until Genius is Proven.” Harry had for years sought to warn the SEC of the fraud he believed was taking place in broad daylight at Madoff. His conclusion was based on careful analysis of public information, the crux of which was that Madoff's purported investment strategy would have required him to trade more than 100% of the available options in certain markets. I loved his book, and I can report that Harry is also an engaging public speaker. One of the items that resonated for me in his book and that Harry confirmed for me in person was that a great many investors in Madoff had concluded, like us, that front-running of brokerage clients was a significant source of their profits. Amazingly, therefore, these clients willingly invested with someone they already believed to be crooked based on the suspect logic that they understood the extent of his dishonesty and that it wasn't going to extend to them. There were some tragic stories of trust built over several decades crushed when everything was revealed. However, it's hard to have much sympathy for people who invest with the expectation that their return is based on exploiting other clients. These people assessed that they were simply passive beneficiaries of what they already believed was illegal activity, and doubtless assumed that when the gig was up they'd be allowed to keep their ill-gotten gains with no consequence. It was a Faustian bargain.