The Hedge Fund Mirage

Unimpressive Returns

Hedge funds trace their origins back to 1949, when Alfred Winslow Jones had the revolutionary idea of balancing long and short positions in an investment portfolio. His techniques, and others developed later, have made some hedge fund managers extraordinarily wealthy. In 2009, the leading 25 hedge fund managers accounted for $25.3 billion in earnings, a minimum of $350 million each. However, hedge fund investors experienced far less impressive returns. In fact, since the inception of hedge funds, Treasury bills have outperformed them.

Hedge fund accounting can mislead in myriad ways. For example, say an investor puts money in a hedge fund and it goes up 50% in the first year. That happy client then adds more money in the second year, but the fund declines by 40%. The investor will show a negative internal rate of return, however, the hedge fund manager will average the returns from the two years and come up with a 5% annual gain. This “geometric return” may appear adequate for the hedge fund manager’s purposes. But – surprise – the investor’s account will still show a loss, not a profit.

Growth of Hedge Funds

Investment cognoscenti...