Measuring the value-added of hedge funds

The co-heads of Goldman’s Global Alpha hedge fund, Messrs. Carhart and Iwanowski, are calling it quits. A few years ago I was running a hedge fund at FrontPoint Partners and we were bought out by Morgan Stanley just in time to attend MSIM’s annual managing directors meeting. All they talked about at that meeting was what MSIM could do to be more like Goldman’s Global Alpha. It was a fierce machine, the gold standard. And it had some years of stellar returns. They rode their hedge fund up to a peak of $12 billion a couple of years ago. Since then they have seen it shrink to $2 billion.

If you are Carhart and Iwanowski, or for that matter AQR’s Asness or Citadel’s Griffin and have a really bad year, at least you can gain some solace by saying to yourself, “Things didn’t roll my way this year, but still, since inception I have on average delivered 15% returns.” Or putting the same sentiment differently, “Even though this has been a hard year, if you had invested $10,000 with me when I started, it would still be worth $300,00 today.”

Actually, no. If you use those benchmarks to define your career as a hedge fund manager, you are doing it wrong. Because hardly any of your investors did put their money with you way back when. In fact, most of them put their money with you over the past three or four years, years where returns moved from hum-drum to disastrous.

I have a hypothesis that would be easy to test with the right data: Some of the large hedge funds that have drawn down substantially in the past year or two have on net lost money for their investors since inception. This, even though they have collected huge fees and have decent average annual returns. The reason I think this might be the case is that in the current downturn they had a lot more money under management, and so had more dollars to lose per unit of poor performance, than when they were knocking the cover off the ball in their early years. Some of the hedge funds that are on the ropes grew larger and larger over time, reaching elephantine size just in time to implode. Some of these were starting to stumble under their own weight in the years before that.

A performance statistic to gauge the overall economic value-added for hedge funds is capital-weighted annualized returns. It would help to answer the question of a hedge fund’s – or the hedge fund industry’s – life-time economic value added; it would be useful even for large hedge funds that have not struggled the way that Global Alpha has. I don’t really care as much about what a $20 billion dollar fund did ten or fifteen years ago when it had $1 billion than how it did in the more recent years when it was trying to put these larger levels of capital to work.

Originally published at the Rick Bookstaber weblog and reproduced here with the author’s permisssion.

4 Responses to "Measuring the value-added of hedge funds"

  1.   April 3, 2009 at 2:31 am

    hmmm… basically , you are saying that hedge funds are “Ponzi schemes” and Madhoffs , less -maybe -the evil intent …I’m not shocked , I’m just trying to gauge if I understood right.Giuseppe Di Bernardo (Sloan 80)

  2. Anonymous   April 3, 2009 at 3:24 am

    Rick, I received a Triple Sell signal written by a Morgan Stanley analyst June 6, 2007, confirming other analysts such as Colin Nicholson. US Yield curve was long negative even then. Sub prime problems were emerging fast even in June 2007. Unambiguously, it was exit time for most sectors especially the Financials. Amazes me that these senior Hedge Fund managers did not immediately commence moving to an overall Market Neutral Position to protect their own careers, going heavily to cash at each subsequent market peak through the remainder of 2007, and balancing their remaining long equity positions with very substantive shorts much as I believe Goldman Sachs did.

  3. Anonymous   April 22, 2009 at 4:09 pm

    While I have seen an untold number of comments about the evil or stupidity of fund managers, such as Messrs. Carhart, Iwanowski, et. al, I have seen absolutely no such commentary about the pension fund managers who invest with them. When those funds started out and had a good process in a space that was not crowded, it was pretty hard to collect assets under management. However, once a fund has a ridiculously outstanding year (mind you, not a good or great year), everyone just piles into the fund. Supposedly insightful chief investment officers of these endowments and pension funds have obviously never heard of a little thing called mean reversion.