Opinion - Retreat of hedge funds would be no bad thing

it is difficult to maintain that, in aggregate, these developments have been a huge success. Experience over the past decade has demonstrated the gulf there can be between what investors think they will be getting from an investment in a hedge fund and the more prosaic reality. Most hedge funds fail, and survivorship bias distorts the performance record of those which remain. The one constant is that hedge funds are expensive. By imposing another layer of fees on top of those being charged by the funds to which they are allocating money, funds of hedge funds make them more expensive still.

In the second edition of his book Hedgehogging, published just as the global financial crisis was gathering pace, Barton Biggs predicted that high fees would be the Achilles heel of the fast-growing fund of hedge funds business. "Large amounts of money under management and high fees spell eventual performance disappointment," he observed. And so it is proving, although it has not prevented much of the money that goes into hedge funds migrating to a small number of large funds with established reputations.

Many would-be hedge fund managers woo investors with promises of pure alpha (outperformance), and charge them mightily for what often turns out to be a good chunk of leveraged beta instead. Those that do generate alpha often find it hard to sustain; and even where they put together several years of good performance, the risk is always that it will be followed by a serious and often catastrophic bust, a phenomenon that stems not just from the use of leverage, but is also implicit in the nature of the strategies many funds adopt.

The way that many quant funds imploded in the summer of 2007 was a nasty eye-opener for those who had been seduced into believing their investments were consistently low risk; while the credit crisis itself demonstrated that many hedge funds offered little protection when the markets turned sour and absolute returns were most needed. Weighed against the economic value hedge funds arguably create through the more efficient allocation of capital, says Andrew Lo of MIT, must also be set the systemic risks which their herdlike and short-termist behaviour create.