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Leading Academics Advise Caution On Hedge Fund Investing

by Phillip Morton, Investors

24 November 2005

High fees, inconsistent data, and difficult-to-understand risks are reasons for individual investors to avoid or minimize their investments in hedge funds, a group of 32 senior financial economists has cautioned in a new report.

The 7-page report by the Financial Economists Roundtable, a group of distinguished finance researchers who have met annually since 1993 to discuss microeconomic policy issues in the United States and elsewhere, believe that the time has now come for the rapidly growing hedge-fund industry to formulate standard measures of performance and risk.

According to the report, this is now necessary because conflicts of interest exist and investors do not have efficient ways to compare the actual performance and risk of the more than 8,000 funds that now hold $1 trillion in investments. Furthermore, a trend towards less wealthy individuals taking stakes in hedge funds, often through funds of hedge funds or through pension funds managed by fiduciaries, make the reason for stricter standards all the more compelling, the economists argued.

However, James Van Horne, professor of Banking and Finance at the Stanford Graduate School of Business, argues that even sophisticated investors may not understand all the expenses and risks involved with hedge fund investing. One example of this is with fee structures known as 'high water marks' where the performance fee is usually 20 percent of performance gains over a set 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."

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. In these situations, standard measures of volatility, such as the 'Sharpe ratio' are "inappropriate" for hedge fund investors, the report said.

Furthermore, the academics warned of the pitfalls of hedge funds' performance data, which they said 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 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 report cautioned.

The group were also not convinced on the merits of funds of hedge funds, which diversify risk by investing across a basket of non-correlated hedge funds, but which also attract a double layer of fees.

"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," the report added.

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