Yes and Not Yes

Yet more on hedge funds and the people who run them and the academics who study them, this time from The New Yorker.

“Hedge Clipping”:

It is well known that risk and return tend to go together. If you go to Atlantic City and bet your life’s savings on a roulette wheel’s coming up black, you have a good chance of earning an instant return of a hundred per cent; you also have a good chance of going broke. Playing roulette is a high-risk, high-return activity. Putting your money in a bank C.D. is a low-risk, low-return activity. Truly outstanding investors, such as Warren Buffett, somehow generate consistently high returns at low risk. Kat decided to determine whether hedge funds met this standard; only if they did could they genuinely be said to have created alpha. In a study published in the June, 2003, issue of the Journal of Financial and Quantitative Analysis, he and a co-author, Gaurav Amin, an analyst at Schroder Investment Management, a British financial firm, compared the fee-adjusted returns of seventy-seven hedge funds between 1990 and 2000 with the returns generated by a market benchmark that had a similar risk profile. Seventy-two of the funds—more than ninety per cent—failed to outperform their benchmarks.

With the help of a graduate student, Helder Palaro, Kat also undertook a larger study, in which he examined more than nineteen hundred funds. The results, which Kat and Palaro posted online as a working paper last year, showed that only eighteen per cent of the funds outperformed their benchmarks, and returns even at the most successful funds tended to decline over time. “Our research has shown that in at least eighty per cent of cases the after-fee alpha for hedge funds is negative,” Kat told me. “They are charging more than they are adding. I’m not saying they don’t have skill; I’m just saying they don’t have enough skill to make up for two and twenty.”

Read the whole thing.