Joshua Brown

Sorry, but hedge funds aren't going away

July 14, 2013: 9:23 AM ET

cash_fist_suit_ju_03Hedge funds may be a media piñata right now, but they aren't going away. Nor should they.

By Josh Brown

FORTUNE -- Over the last month, the low hum of anti-hedge fund murmuring has exploded into a full-on festival of malice -- thousands of investors, having spotted the 2-and-20 emperors sans clothing for the umpteenth time, are now reveling in their newfound courage to say it out loud:

"I don't get it." 

The journalists -- always in possession of a keen nose for blood in the water -- have been all too happy to encircle the debate with articles, viewpoints, charts, and statistics (oh so many statistics). The sheer size and scale of this multi-trillion dollar industry has never made sense to them, and the manager paychecks they've been forced to report on were always cartoonish. It's only natural that they should be luxuriating in this moment.

For non-hedge fund finance professionals (asset managers, wealth managers, traders, financial advisors, etc.) the narrative is an equally delectable one: "Hey, wait a minute! That a-hole in the Tod's driving mocs makes 10 times as much as we do and returns less than half as much to his clients! LET'S GET HIM!"

And the retail investor is also enjoying the public shaming. Because you cannot find a single one who doesn't feel -- deep down -- that the game has always been unfair to them because the hedge fund managers have some sort of secret (read: unfair) advantages in the market.

So the stockades are being erected in Greenwich's village square as we speak. Anti-hedgian rhetoric can be read and heard everywhere all at once this summer -- but its tone is more mocking than angry. Yes, the townspeople are holding their torches aloft, lit with the fires from a decade's worth of pent-up envy, but they are laughing not shouting. Witness BusinessWeek's limp dick cover, one for the ages to be sure.

The emerald curtain's been pulled back and, with the exception of George Soros and a few others, the wizards are only men in suits, scrambling for their ephemeral "edges" just like the rest of us.

Here are the key takeaways, in my mind:

1. There is a small group of hedge fund managers who can consistently beat the market as a result of their hard work and innate brilliance. This small group of hedge funds does not want you as a client.

2. There are many, many other hedge fund managers who will have good years, great years, and terrible years in no predictable semblance of order. Much of this will depend on the market environment and luck, very little of it will prove to be repeatable.

3. The worst thing that can happen to a manager is a multi-year run of market-beating success. This is because two things are inevitable as a result: First, he will raise a lot of money, which will render his market-beating methods impotent. Second, he will begin dating really hot girls, traveling a lot and enjoying his fortune. And who could blame them? The problem is, none of this really leads to alpha. As Clubber Lang menacingly shouted at the champ in Rocky III, "You ain't been hungry since you won that belt!"

4. There is a larger question as to whether or not hedge funds can reliably generate alpha: Does it matter? I suppose if you've got $50 million to invest, who cares? And if you're a pension or endowment manager, adding hedge funds looks smart -- especially the larger funds -- so why not?

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5. There are some great emerging managers out there who can make their early limited partners (the investors) very wealthy. Unfortunately, this is a needle-in-the-haystack type of proposition. The nation's fund-of-funds complex has been shown by the research to be unable to identify these emerging managers. They have the data, analytics, personal connections, real-world experience and educational pedigrees in spades -- and they cannot do it. Why you think that you can is beyond me.

6. There was a time when hedge funds could do quite well for themselves by virtue of the fact that there were so few of them that the inefficiencies were immensely profitable. That's been over for more than a decade now. It's not coming back. But this doesn't mean that all inefficiencies are gone -- or that talented managers will not be able to suss them out profitably.

7. The hedge fund industry is racing to open '40 Act Funds (mutual funds) and convert their strategies to so-called liquid alternative products. In doing so, they are reducing the fees and the minimum initial buy-in -- to just $1,000 in some cases. This rush to take in retail money includes everyone from Goldman Sachs (GS) to Kohlberg Kravis Roberts & Co. (KKR). But you should not be surprised -- think of it like when you see luxury brands popping up in TJ Maxx or Marshalls. The products you are encountering are not high-end fashion duds that found themselves into the discount store. No, they were made specifically for these off-the-rack retailers as part of a business strategy. By the same token, you will not encounter a product giving you entree into the best hedge funds through Charles Schwab (SCHW).

8. Given the exodus from active strategies into passive products in the last few years, it is a virtual certainty that many hedge funds are going to see a renewed opportunity to generate alpha and outperform. The question is whether or not that will matter to their investors by the time one factors in fees. Some people will track that "cost of alpha" to within a penny. Most won't.

9. The argument that "hedge funds are non-correlated so they make sense for most portfolios" is nonsense. When stocks go down, cash is non-correlated too and it costs nothing. When stocks go up, who wants to be non-correlated? One quant I know -- who cannot say this in public given his client base -- has run a variance optimization test on the hedge fund universe and determined that, in the long-run, they are statistically no different from a half-stocks, half-treasuries portfolio with an enormous price tag attached. But so what? If you own a hedge fund that goes down 10% while the market drops 30%, you're going to be pleased with yourself and you know it.

10. Not every fund investment needs to be about performance. Some people just like knowing the smartest, slickest guy in the game is running their money and the results are an afterthought. Some people like the quarterly letters or the ability to tell their golf buddies "I'm with Einhorn." You will see this when the advertising begins, by the way. It will be very much about aspirational branding and lifestyle. This will be image advertising -- think Calvin Klein's Obsession, not "Four Suits for Four Dollars at Joseph A Banks!" And what's wrong with that?

The bottom line: Not everything in life needs to come down to stats. People have a variety of reasons for being in hedge funds, from the way it makes them feel to the way it differentiates their portfolios -- all of them valid on either a financial level or an emotional level or both. That $2 trillion in hedge fund AUM is not going to shrink in the future, it is going to grow. This is because there will always be new superstars with new ways of investing and generating returns. And the best of these managers will frequently opt for the wrapper in which they're paid the most for their efforts. It's hard to beat the management-plus-incentive structure.

The best and brightest will always go where the pay is the highest -- and investors will usually follow them there, for better or for worse. This will not change in our lifetimes so let's all settle down.

Joshua Brown is a New York City-based investment advisor for high net worth individuals, charitable foundations, retirement plans and corporations. He blogs at TheReformedBroker.com.

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