Hedge Funds’ “Dirty Little Secret”

As you walk along the Georgian townhouses on the streets of Mayfair — the epicenter of the hedge fund industry in London — there’s little sign of the global financial crisis. Rolls-Royces and Bentleys are parked along Berkeley Square, with their crisply dressed chauffeurs patiently waiting for their owners to emerge from nearby buildings. The bar at Claridge’s Hotel, as well as several new designer boutique hotels opening just in time for the 2012 Olympics, are buzzing with their prosperous, cosmopolitan clientele.

Yet, a friend with whom I was having drinks at the Lansdowne Club was complaining. His fund recycles profits from Middle Eastern United Arab Emirates oil and gas reserves. And his employers are making money faster than they can spend it. That means he has to spend his life travelling the world, snapping up trophy assets on a sheik’s whim.

The legions of hedge funds within a stone’s throw away have a different problem. On the one hand, London is the world’s number-two center after New York for the $2 trillion hedge fund industry. On the other, compared to the Russians and Arabs of Mayfair, hedge funds are the working stiffs of the neighborhood. And like their blue-collar brethren in Ohio and Michigan, they haven’t exactly been making money hand over fist in the past three years.

Even the Babe Ruths of the hedge fund industry have had it rough. Both John Paulson and Phil Falcone suffered 30-40% losses last year in their largest funds. Even the grandmaster of them all — George Soros — ended 2011 down 15%. This is the same George Soros who actually made 10% or so during the financial meltdown of 2008.

The global hedge fund industry is over praising and under delivering. The S&P 500 index has now outperformed the average hedge fund for three years running. The index continued to do so in the first three months of 2012. Most hedge fund managers I know were caught flatfooted by the recent rally. And their big bets on commodities also turned sour.

Hedge fund managers will argue that on a “risk-adjusted” basis, they have done okay. That’s another way of saying that they’ve provided investors with a smoother ride. During the financial meltdown of 2008, hedge funds lost 19% and the S&P 500 lost 37%. But clients are quick to forget the pleasure associated with a 20% loss. And the argument that “I lost less money than the other guy” is not a winning marketing mantra.

The poor performance of hedge funds has led some investors to question the entire industry. Maybe hedge funds have gotten just too big for their own good. Marco Avellaneda of New York University argues that the $2 trillion hedge fund industry is already there. In a 2005 study, Avellaneda calculated that for every doubling in assets under management, the hedge fund industry’s returns fall 1.92%. At the time he published the study, the assets of the hedge fund industry stood at $1 trillion. Once the hedge fund industry’s assets hit $2 trillion, it would mean returns would be no better than the S&P 500 index. In fact, based on the last three years, the hedge fund industry seems to be doing even worse.

Why? Too many managers are chasing too few “best ideas.” Throw in pressure on fees; the fact that the top 100 hedge funds control 60% of the industry’s assets, leaving little room for new entrants; and the soaring costs of increased regulation. The dirty little secret is that the hedge funds aren’t the road to riches that they’re cracked up to be.

So, if it’s not hedge fund managers making a mint, who is driving all of the Bugattis and Rolls-Royces in Mayfair? It turns out these luxury cars are more likely to be driven by a Saudi Prince or a scion of a Russian oligarch than by a Wharton grad who paid himself a big bonus from the big profits in his U.S. long-short equity hedge fund.

So the best way to become part of the global 1% is to be born into a rich family in the Middle East or in Russia.

But there is an alternative. I’ve had several (working-stiff) friends get stinking (as in at least $15 million) rich over the past year. Their secret? They all worked for and then cashed out of technology companies that had hitched their wagon successfully to either the Apple or Facebook juggernauts.

Not a single one made his millions by running a hedge fund. In fact, successful technology investors, such as Facebook angel backer Peter Thiel who tried his hand at becoming the next George Soros, got their heads handed to them.

The lesson? Hedge funds are not an easy road to riches. And with returns diminishing, the industry may be near the end of its current growth cycle.

Sincerely,

Nicholas A. Vardy
Editor, The Global Guru

P.S. Please join me for the Las Vegas Money Show, May 14-17, at Caesar’s Palace. To register, call 1-800/970-4355 and mention priority code 026655 or go to NicholasVardy.lasvegasmoneyshow.com. I also encourage you to sign up for my hedge fund seminar, Wednesday, May 16, 9 a.m. – 11 a.m.