Capitalism works best when information flows most freely. Under such conditions, its powerful self-regulator kicks in, attracting new players to areas where excessive profits are generated and punishing those who under-deliver. Given that they are exposed in both areas, it’s no surprise hedge funds are being pummelled.
Nine years back Warren Buffett famously put down $500,000 of his own money when he offered it in a bet against any hedge fund which believed it could beat the S&P500 index. With only months left, the hedgies who took the bait have taken a pasting. Here’s another nail in the once flourishing hedge fund coffin, courtesy of academic research uncovered by my Biznews colleague Jackie Cameron.
Jackie writes: “As a personal finance journalist, I’m constantly on the lookout for fresh ideas for money stories. One of my favourite hunting places is in academic research, where innocuous sounding papers can conceal the most interesting investment revelations – though it may take some work to decipher the technical details.
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Take, for example, this paper, which was in the publishing queue for some years at the Journal of Finance: ‘Change You Can Believe In? Hedge Fund Data Revisions’. Andrew Patton of Duke University, Imperial College London’s Tarun Ramadorai and the University of Oxford’s Michael Streatfield did an enormous amount of number-crunching on hedge funds, coming up with a useful indicator on which hedge funds to buy or sell.
In a nutshell, as soon as you get wind that your hedge fund manager has revised his or her past performance, you should cut loose as your money could easily be put to better use elsewhere, is their conclusion. This applies whether the correction is up or down, with this research team finding that ‘selling hedge funds as soon as they revise is a sensible strategy, generating higher returns’.
What’s more, tweaking the numbers is more common than not in the hedge fund sector, which raises the question of whether you should be investing in hedge funds at all. After analysing data between 2007 and 2011 on more than 12,000 funds with an average life span of just over six years, Patton and team found that many hedge fund managers routinely modify past performance disclosures.
‘Some of these modifications were tiny, but around 30% of managers revised past monthly performance by 0.5%, or more,’ with the study suggesting that funds which revise performance histories ‘significantly and predictably underperform in the future, relative to those who have never revised’. The researchers go as far as to say that the findings raise suspicions that hedge fund managers make phoney corrections or push legitimate corrections to ‘reset high-watermarks’ and in so-doing put themselves in line to earn higher fees.
Patton and friends note, too, that in the light of this performance data jiggery-pokery, it is not surprising that hedge funds have lobbied against mandatory disclosures. Hedge fund managers like to push for keeping details under wraps on the basis of worries about disclosing trade secrets, but the university finance academics clearly don’t buy that excuse.
These findings come on the back of reports that hedge funds have failed to deliver decent returns for investors year-in and year-out for several years. Patton and his research colleagues note that their study ‘suggests that unreliable disclosures constitute a valuable source of information for current and potential investors’ in hedge funds.
In the interests of helping investors, they have made their full paper available beyond the Journal of Finance firewall. It has pride of place in the Saïd Business School (University of Oxford) research showcase here.”
With the information flowing freely and compelling evidence making the case against hedge funds, you have to wonder how this once hugely successful sector still survives. Perhaps it’s a case of high pressure marketing continuing to fool some of the people some of the time. Don’t be one of them.
