Does The Hedge Fund Industry Benefit Society?

Mar 24 2015 | 10:15am ET

By Donald A. Steinbrugge, CFA
Managing Partner, Agecroft Partners

It is no secret that the hedge fund industry is viewed negatively by a large portion of the general public, but should it be? Such a perception is driven primarily by the fact that most hedge funds are not permitted to market themselves to the general public, and because the mainstream media has a negative bias toward their coverage of the industry.

The average person is inundated with negative articles creating the image that:  1) Most hedge fund managers are dishonest and frequently commit fraud or violate insider trading laws. 2) Hedge funds are highly risky investments. 3) Their devious actions are bad for the general public. 4) Hedge funds generate bad performance and their fees are too high.

Is the general’s public perception of the hedge fund industry equal to reality? Let’s take a closer look at each one of these points:

1. Is the average hedge fund manager dishonest? Of course not. The industry is not comprised of a bunch of Bernie Madoffs, as many people would believe. Agecroft Partners estimate that there are more than 15,000 hedge funds in the market place and a vast majority of these are run by honest business people trying to do the right thing for their clients. The reality is that multiple times more money has been lost by investors due to fraud in public equities and fixed income securities. Some of the largest frauds in history included Enron, WorldCom, Tyco International and Health South. There is not enough room in this paper to include all the penny stock companies that have gone out of business. 

CEOs of publicly traded companies are heavily biased in articulating the future prospects for their company and often there is a large grey area relative to what is stretching the truth and what is crossing the line. When was the last time a CEO did a road show and said “our products are really bad, our head of R& D is completely incompetent and I am over my head in this position. This is a great time to short our stock.” If this is the case, why must hedge funds include disclosures in their presentations that are slightly less scary than what appears on cigarette packages while buying a publicly traded stock does not?   

2. Are hedge funds risky? The answer to this question depends on the definition of risk. The average volatility of hedge fund indices is a little more than half the volatility of equity indices. Relative to downside risk, in 2008, the MSCI world stock index was down over 40% which was more than double the decline of the average hedge fund.

Typically, owning an individual stock has significantly more downside risk than an individual hedge fund which owns a diversified portfolio of securities. In 2008, many companies’ stock price declined 90% to 100% in value over a short period of time, which included such prominent companies as Bank of America, Lehman and Merrill Lynch.  Many institutional investors are increasing their allocation to hedge funds in order to reduce the overall volatility of their portfolio. Not only does a diversified portfolio of hedge funds have a lower volatility than an equity portfolio, it also can provide low correlation to other asset classes which reduces overall portfolio volatility.

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