Anyone with a bad word for hedge funds these days can have it published no matter how little they know of the subject.  The latest bad word comes from Arne Alsin, a mutual fund manager who seems to know nothing whatsoever about the the behavior of hedge fund investors.  Portions of his column from yesterday's Financial Times are reproduced in italics below.  My comments follow.


Arne Alsin

"If people carefully considered the structural deficiencies before investing, most would never invest. Hedge funds are not designed to serve the best interests of investors. They are designed to serve the best interests of hedge fund operators."

A mutual fund manager might not realize this, but the typical hedge fund investor doesn't go to his financial advisor at the Edwards Jones office down by the Steak and Shake to figure out where to put his money.  Pension funds, endowments, foundations, funds of funds and, yes, even wealthy individuals do a fair amount of due diligence when investing in hedge funds.  This due diligence checklist sets out the kind of going-over a non-elite hedge fund manager can expect to receive.


Photo: Hedge fund investor prepares for due diligence probe.

As for hedge funds being designed to serve the best interests of operators rather than investors, I can only say that we still haven't figured out how to convince investors to pay performance fees in down years!

"What are the attributes that should make investors wary?

First, lack of transparency: hedge fund investors are at a significant information disadvantage compared with investors in other instruments. For example, the owner of a brokerage account can go online and see exactly what he or she owns and how much it is worth at any hour of the day, on any day of the year."

This is silly.  People don't go to flight training school before flying as passengers on airplanes, and investors in KFC aren't entitled to the Colonel's secret recipe.   Hedge fund managers are pilots and their investment program is their special sauce on the Big Mac.

For the sake of all investors in a fund, managers shouldn't provide positional details to any investors.  They're called trade secrets.  If they seep into the market, a fund's performance suffers.  Unlike the typical mutual fund investor, the typical hedge fund investor has the means and ability to act on its funds' strategies in ways that dampen returns.  Personally, I insist on positional opaqueness from my managers.

Photo: Percy's Investment Strategy, kept in a safe until Percy's death or permanent disability.

Many hedge fund investors nevertheless insist on receiving positional and leverage information and many, many managers are willing to provide it to them, even daily.  So, Mr. Alsin is wrong in more than one way.

"It is a mistake, for example, to be impressed by a hedge fund that claims to have generated returns of more than 40 per cent annually for three consecutive years. An informed judgment cannot be made solely based on a nominal rate of return. Does the fund use a lot of leverage? Are there illiquid or hard-to-value holdings? Does the fund set aside holdings in side pockets? Does it invest in speculative securities? Is there exposure to derivative contracts?"

If you have a chance to invest in a fund that has generated returns of 40 per cent annually for three consecutive years, you are an idiot not to invest in it.  Also, there are things called offering memorandums, limited partnership agreements and side letters that discuss and provide limits on leverage, valuations, side pocketing and the types of securities in which a fund invests.  Investors read and rely on them.  Not living up to them is actionable.  Also, see that due diligence check list linked above.  Due diligence is something hedge fund investors actually do. 

Does Alsin know anything at all about investing in hedge funds?

"Further, hedge funds have a misaligned incentive structure. The typical hedge fund charges at least a 1 per cent annual management fee plus 20 per cent of profits. This fee arrangement is aligned nicely to a hedge fund manager's objective of getting rich. It is not aligned with investor goals such as long-term wealth accumulation or funding retirement."

In the real world, hedge fund managers have a significant amount of their net worth tied up in their funds.  Investors insist upon it.  An investor will lose less of its overall net worth in a blowup than the typical fund manager.

Blow-ups also tend to lead to lawsuits against fund managers.

"Last, hedge funds lack accountability. Because the industry is unregulated, any and all information promulgated by the funds should be viewed with caution. Without regulatory scrutiny and disclosure on how returns are generated, investors have a right to be sceptical."

The market has regulated many hedge fund managers into providing the information that Mr. Alsin claims isn't provided.  There are also regulations that prevent the vast majority of people from investing in hedge funds in the first place, not to mention the ridiculous requirement that managers with more than $100 million in publicly traded equity provide quarterly disclosure of their positions.  Hedge funds are overregulated.