Hedge Funds: Myths & Facts

By: Ed Easterling, Crestmont Research
Published: April 10, 2007

Hat tip to Opalesque for highlighting this report containing 15 hedge fund “myths”.  Ed Easterling, author and prof at Southern Methodist University’s Cox School of Business, hits the nail on the head with this observation about the accusations commonly leveled against hedge funds:

“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.”

Why all the anti-hedge fund hyperbole?  According to Easterling, there are three sources:

  1. “…academics that are misapplying principles of finance and markets to hedge funds or that are repeating seemingly-logical perspectives,
  2. “…high-profile observers from outside the hedge fund industry that lack actual knowledge, and
  3. “…critics of the hedge fund industry that relish in attempting to discredit it.”

We won’t list out all 15 myths here.  But the following 5 are worthy of particular note:

Poor Performance: Easterling argues that comparing hedge funds to equities is wrong-headed since the capital allocated to hedge funds is often taken away from stocks and bonds.  In any case, we add, it makes no sense to use equities as a benchmark for, say, an equity market neutral fund.  Furthermore, the simple fact that hedge funds have a lower volatility (in aggregate) than the market means they are destined to outperform in flat to weak markets and underperform in bull markets.  This exposes the fatal flaw in hedge funds (vs. the index): if you’re that woman on that show Medium who sees yet-to-be-committed crimes in her dreams or that Scottish guy on Lost who has flashbacks from the future, then you can make way more money timing the S&P 500.

High Leverage: Despite the fun stories from the LTCM or Amaranth debacles, hedge funds employ between 1.2 and 1.5 times leverage according to research cited by Easterling.  If you’re searching for leverage, though, look no further than a typical high beta growth fund which has a lot of leverage – embedded in the balance sheets of the funds holdings as opposed to the books of the mutual fund itself.  (Ironically, recent research on the CAPM shows that levering up a low beta stock is better than actually buying a high beta name outright).

High Attrition: Easterling points out that the supposed excessive failure rate of hedge funds is a product of the databases to which many funds report.  He says that poor performing hedge funds may cease to voluntarily report their numbers, but that doesn’t mean they go bankrupt.  Unlike the mutual fund industry, where public disclosure is required, hedge funds can begin or cease reporting as they please.  So it’s a stretch to conclude that all non-reporters actually failed – especially when the average hedge fund reports to one or two of 10 or more databases.

Easy to Start: Ah, the good olds days.  Notwithstanding the shrink-wrapped “hedge fund start-up in a box” solutions being offered by accountants, lawyers, administrators, prime brokerages, and your local WalMart, it’s recently been said that it now takes about $200 million to make a go of it.  But even if it were as easy as ever to launch a fund, that doesn’t mean you will ever expand beyond the “friends & family stage”.  Saying it’s easy to start a hedge fund is like saying it’s easy to become a lawyer.  Sure, but you can work on Boston Legal or with Danny DeVito in John Grisham’s The Rainmaker.  Clients know the difference – and Boston Legal’s William Shatner isn’t losing any sleep over Danny DeVito stealing his clients.

The only myth we’re not sure we fully agree with involves hedge fund replication.  Easterling wades into this debate by pointing out that it’s no surprise hedge funds have been correlated with the market over the past 5 years, since the market has risen over this time (the suggestion being that hedge funds will continue to rise even if markets tank).  This is a valid argument and one also made by Alexander Ineichen.  But Easterling’s branding of hedge fund replication as a “freshman mistake in statistics” is a little far-fetched.

We’ve reviewed dozens of academic papers on this topic and interviewed several of the world’s experts in this area, and we can’t believe that all these guys (they are all “guys”) have made the same rookie mistakes.  In this landmark study, Bill Fung, David Hsieh et al analyzed data from 1995 to 2004 and discovered a lot of beta (just not all of the equity long-only variety).  Still, perhaps it’s true that with so much benchmarking against the equity markets in the popular media, freshman hedge fund investors might overestimate the correlation between the two.

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One Comment

  1. Hedge Fund
    January 24, 2008 at 5:28 pm

    I actually wrote a not so different article for the Albourne Village last week entitled “Top 10 Hedge Fund Myths.” Here is a link if anyone is interested:

    Top 10 Hedge Fund Myths

    http://richard-wilson.blogspot.com/2008/01/top-10-hedge-fund-myths.html


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