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Hedge Funds….WTF Did They Make?

Recently I came across two contradictory positions that I am trying to reconcile. I was researching the return for hedge funds for 2011 when I came across the RBC Hedge Fund 250 Index. According to the blurb –

The RBC Hedge 250 Index is a non-investable benchmark of the performance of the hedge fund industry based on a universe of 4,172 hedge funds (excluding funds of hedge funds) with aggregate assets under management of $1.005 trillion.

Their data states that the index lost 2.9% for 2011 with the best performer being fixed income arbitrage which gained 7.38% for the year. Whereas, managed futures were the worst performer losing 8.02% for the year. These numbers seem reasonable and they tally with expectations. After 2011 was a shocking year and was particularly difficult for any form of trend following.

However, upon digging a bit deeper I came across a blog post in the Economist that looks at returns as they appear in a book called The Hedge Fund Mirage – The Illusion of Big Money and Why Its Too Good To Be True. They could have just gone with the title The Hedge Fund Mirage by publisher do need to make themselves relevant.

This book written by Simon Lack contends that the entire industry is somewhat fast and loose with their stats. His opinion is that the industry instead of making the annualised 7% or so that they claim actually makes on average around 2.1%. In fact the average return since 1998 is less than one could have got in fixed interest. The difference apparently arises due to the method used to calculate returns. As an example consider this if I have a fund that makes a 100% in the first year and then a 50% loss in the second – what is the average rate of return?

(100-50)/2 = 25%

So I can say my rate of return is 25%. However, if you add in real money the story is a little different. If I invest 100k at the beginning of year one how much do I have at the end of year 2?

$100,000 x 100% = $200,000 at end of Year 1

$200,00 x (-50%) = $100,000 at the end of Year 2

Effectively I haven’t made a cent but my hedge fund manager has if they are taking 25% of profits. Lack uses a method known as internal rate of return to calculate hedge fund returns and this is where part of the discrepancy lies. Part of the problem also lies in the use of hedge fund indices such as the RBC index since all indices have inflated performance due to survivor bias.

The question remains as to how much do hedge funds actually make their clients – I will leave the final word to the Economist

There is no doubt that hedge-fund managers have been good at making money for themselves. Many of America’s recently minted billionaires grew rich from hedge clippings. But as a new book* by Simon Lack, who spent many years studying hedge funds at JPMorgan, points out, it is hard to think of any clients that have become rich by investing in hedge funds (whereas Warren Buffett has made millionaires of many of his original investors).

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