From the corridors of academia comes a paper surely considered blasphemous — or at least bad PR — by hedge fund managers: It raises questions about whether hedge funds are worth their fees. Written by Kenneth French, a finance professor at Dartmouth’s Tuck School of Business well known for his research on markets, the working paper, “The Cost of Active Investing,” suggests that passive investors — those who put money into index funds — do better over the long haul than active investors like hedge funds.
Discussing the issue in an “I’m just asking” tone, he cites data from 1980 through 2006 that shows how a passive portfolio would have beat the value-weight average of all active and passive investors by 67 basis points a year. It’s been said before. What French brings to the table is an unusually hard look at hedge funds. He calculates that 0.13 percent of the entire value of U.S. equities in 2006 was eaten up by hedge fund management fees, up from 0.04 percent in 1996. Extending part of his study into 2007, he finds single-manager hedge fund fees — especially when combined with fund-of-funds fees — “a stark illustration of the negative-sum nature of active trading.”
French says the value-weight average fee for U.S. equity-related hedge fund assets last year was 4.63 percent. The average fund-of-funds fee was 1.85 percent. As a result, investors in a fund of funds would have needed the underlying managers in which it invested to produce excess returns of 6.48 percent just to cover all their fees. French estimates that at the start of 2007, there was $458.6 billion in U.S. equity-related hedge funds, which he says had to take $29.7 billion in profits from other U.S. equity investors for their fund-of-funds clients to break even.
“With somebody like Jim Simons, every billion he takes out is a billion somebody had to put in,” notes French, referring to the founder of Renaissance Technologies Corp., whose Medallion Fund has delivered an annualized return of 40 percent since 1988.
“My hope is that just by seeing the stark numbers, some investors will go, ‘Oh, okay, now I get it: It really is a negative-sum game.’”
