(First published in 2011)
The news that George Soros is throwing the last outside investors out of his Quantum fund and keeping it solely as a family office from now on provides a useful reminder that hedge funds are facing increasing obstacles, of which the regulatory requirements which prompted this move are just one. If they go back to being what they once were, namely private pools of capital with a finite number of owners and fend-for-yourself regulation, the investment world would, in my view, be no worse a place as a result.
After such a successful career, which has seen him clock up compounding returns of more than 20% for nearly forty years, Mr Soros has little need to worry about the state of the industry. At the age of 80, having changed the nature of his fund at the start of the century away from aggressive return-seeking in favour of wealth preservation, he can afford to look back on an extraordinary, if stressful, investment career with some satisfaction.
Although the Quantum Fund’s returns in the last 18 months have been indifferent, including a loss in the first six months of this year, and in recent years Mr Soros has focused only intermittently on direct involvement in the management of the fund, his long term track record has been exceptional. If it is true, as has been reported, that the fund currently has 75% invested in cash, it is an extreme example of the kind of high conviction decision-making which has been his hallmark and which narrow or family ownership entitles – and in practice almost alone enables – an investment manager to make.
Many others have tried to match the investment success which the Quantum Fund has enjoyed over many years, but only a small number can really claim to have succeeded. True, the stampede by investors into hedge funds which began just as Mr Soros was scaling back his ambitions 12 years ago has produced several years of rapid growth in assets under management and in turn spawned an entirely new industry of professional gatekeepers, in the shape of consultants and funds of hedge funds.
But it is difficult to maintain that in aggregate these developments have been a huge success. Experience over the past decade has demonstrated how big a 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 yet another layer of fees on top of those already 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 delightful book Hedgehogging, published just as the global financial crisis was gathering pace, Barton Biggs predicted that high fees would prove to 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 still 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, and charge them mightily for what often in practice turns out to be a good chunk of leveraged beta instead. Those which do generate alpha frequently find it hard to sustain that record; and even where they do put together several years of good performance, there is often a risk 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 which some 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 that their investments were consistently low risk; while the credit crisis itself demonstrated that many hedge funds in practice offered limited protection when the markets turned sour and absolute returns were most needed. Weighed against the economic value which you can argue hedge funds may create through the more efficient allocation of capital, says Prof Andrew Lo of MIT, must also be set the systemic risks which their herdlike and short termist behaviour creates.
The wonder really about hedge funds is not that supply continues to grow at a steady lick. As a means for enriching fund managers, they continue to offer unrivalled opportunities for those with ambition and a plausible story. The wonder is rather that demand has proved so immune to disappointment. As a retail offering, and even for institutions, the problems of high fees and the misalignment of interest which are implicit in hedge fund construction cannot be easily resolved. If greater regulation has the effect of shrinking the industry, or increasing the penalties for failure, it would be no bad thing.