Tuesday, November 1, 2005

Economists Caution Investors on Hidden Risks of Hedge Funds

STANFORD GRADUATE SCHOOL OF BUSINESS—High fees, inconsistent data, and difficult-to-understand risks are reasons for individual investors to avoid or minimize their investments in hedge funds, caution a group of 32 senior financial economists, including three from Stanford, in a new report.

The rapidly growing hedge fund industry badly needs standard measures of performance and risk, the economists say, because conflicts of interest exist and investors do not have efficient ways to compare the actual performance and risk of more than 8,000 funds that now hold $1 trillion in investments. The economists also recommend that banking regulators discourage speculators from taking big risks with hedge funds by making it clear that the government will not rescue troubled funds in the future.

These concerns are detailed in a 7-page report by the Financial Economists Roundtable (FER), a group of distinguished finance researchers who have met annually since 1993 to discuss microeconomic policy issues in the United States and elsewhere. Their report reflects a consensus among the majority of members who attended the 2005 meeting in July and is signed by 32 members who supported the statement.

The signatories include three from Stanford: James Van Horne, the A.P. Giannini Professor of Banking and Finance at the Business School; Kenneth Scott, the Ralph M. Parsons Professor of Law and Business, Emeritus, at the Law School and a senior research fellow at the Hoover Institution; and Nobel laureate William Sharpe, the STANCO 25 Professor of Finance, Emeritus, at the Business School. (Sharpe is also a founder of Financial Engines, a company that provides investment advice to employees of companies that hire the firm.)

Hedge funds are typically private, largely unregulated limited partnerships with wealthy individuals and institutional investors as limited partners. Increasingly, however, less wealthy individuals take stakes, often through investment offerings composed of multiple hedge funds or through pension funds managed by fiduciaries. Congress in 1996 also lowered the financial requirements for individuals to make direct investments in hedge funds. The Roundtable recommended that, because of the risks involved, even knowledgeable fiduciaries should make only "modest" investments for individuals in hedge funds.

Investors generally know that management fees are high compared to other investment vehicles, said Van Horne, who participated in the Roundtable discussions and helped write the report. But even sophisticated investors may not understand all the expenses and risks, he said. Take, for example, the incentive fee that general partners often get for performance gains over a set threshold, referred to as the "high-water mark." The fee is usually 20 percent of performance gains over the threshold. "One consequence often overlooked by the investor, Van Horne said, "is the fact that when cumulative returns fall below the mark for generating fees, the general partner can close the fund in order to establish a new base for setting fees."

"The asymmetric fee structure creates an incentive for the general partner to adopt a high-risk investment strategy, since he/she stands to make a large return if the strategy is successful but not to suffer losses if the strategy fails," the Roundtable report states. Investors try to offset this risk by making sure the general partner has a sizeable investment in the fund. "Nonetheless, the average life of a hedge fund is only about 3 years," the economists note.

Another risk relates to the lack of a normal distribution curve in hedge fund returns. Losses can come on suddenly and dramatically, creating what is known as "tail risk," similar to what happens to currency investors when monetary authorities suddenly devalue a currency sharply. Standard measures of volatility and performance, such as the Sharpe ratio named for William Sharpe, are inappropriate guides for investors in tail situations, the Roundtable group said.

"In addition, risk-adjusted average returns tend to be overstated, because of survivorship bias and other reporting and data problems, making it difficult to compare hedge-fund performance with competing alternatives," the group report states. "The investor, particularly the retail investor and his/her agents, should be wary; available performance data make it difficult to judge true hedge-fund returns and risk for this high cost vehicle."

The group did not reach a total consensus on the wisdom of investing in funds of funds, which add another layer of fees to already-high fees. The advantage is supposed to come from added diversification.

"Some of us suspect that the services provided by some funds of funds are worth the cost, and they make the market for hedge funds more efficient," the report says. "Others of us believe that with some 8,000 hedge funds playing against each other in many of their strategies, there surely will be losers—particularly when the high costs are taken into consideration. All of us believe that funds-of-funds-of-funds, F3s, which invest in funds of funds, do not have a favorable cost/benefit ratio."