THE BLOG
07/26/2013 04:51 pm ET | Updated Sep 25, 2013

Do Hedge Funds Really Need Viagra?

The cover of the most recent Bloomberg BusinessWeek magazine is already creating controversy, which is sure to build; perhaps the point. Its obvious phallic nature, with the title "The Hedge Fund Myth," will create squeamishness among media critics and praise from those folks who tend to like that sort of pushing of the envelope. But what I find interesting is the target and how the target group, hedge funds, is probably what gave the editors the confidence to be this bold.

It is not appropriate to target certain groups for criticism and that list has grown over the years, but many people like to take their digs and rich hedge fund managers are an easy target. And to do it in such a sexual manner is an interesting decision.

What is being communicated is that these guys are not the studs producing strong returns many folks believe them to be but weak (limp) pretenders. Are they right or this just another case of the traditional business media protecting the traditional investment world?

I would vote on the latter as the headlines themselves are so incendiary that they tend to be comical -- again much more to do with the target than the facts. The issue includes these headlines for example: "Hedge Funds are for Suckers," and "Hedge Fund Hijinks To Continue After SEC Move."

IF UNDER PERFORMANCE PERSISTS FOR 4 YEARS CALL YOUR BROKER

Obviously it will take more time and research to provide a quantitative rebuttal to Bloomberg's ah er thrust, but let's start with a few simple facts. Hedge funds generally are absolute return alternative investment vehicles created to earn returns above the risk free rate or "alpha" when traditional investments struggle, so it doesn't make too much sense to compare them to traditional assets in a bull market and criticize them for under performance. Bloomberg BusinessWeek would be the first to defend the performance of long equity mutual funds in a bear market. The point being there will be both bull and bear markets and investors should have the ability to diversify so they are not wiped out in years like 2008.

Inclusion of alternatives in a portfolio tends to improve returns and, more importantly, reduce overall volatility. Anyone can pick better or worse strategies over certain periods of time but it is always beneficial to have non-correlated investments that tend to smooth your overall portfolio.

The general business media usually includes managed futures in the broad umbrella of hedge funds but I don't recall the following headline in any mainstream business publications: "Managed Futures the only asset class to earn strong returns in 2008."

But it was. And, quite comically, there was a study put out by the Yale International Center of Finance in October 2008 titled: "Fooling Some of the People All of the Time: The Inefficient Performance and Persistence of Commodity Trading Advisors." http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1279594.

It was comical because of the timing as the stock market crashed in 2008 and even most equity based hedge funds and diversified fund of funds tanked but CTAs had a tremendous year and this study came out in the midst of it saying that Managed Futures was a terrible investment choice and basically that the people who invested in it were simply too stupid to know better. Yet CTAs produced outsized performance in 2008 on an absolute return basis as well as against all other investment vehicles.

Adding to that comedic value of this dubious study is that one of the authors, Geetesh Bhardwaj, hailed from AIG Financial Products, the arm of the insurance giant that had to be bailed out in the fall of 2008 and had a significant role in the credit crisis through its trading of credit default swaps.

However, Bloomberg BusinessWeek did seem to be focusing on what we would generally consider hedge funds though they tend to include CTAs in this group when it suits their purposes.

For now let's focus a little on lifting the advertising ban. First off the author of this commentary seems to be confused in putting this in the lap of the Securities and Exchange Commission (SEC). While I usually never skip a chance to criticize the SEC, lifting the ban on general solicitations by private placements was part of the JOBS Act passed by Congress and signed by the President last summer. The SEC simply had to write rules for it but the author, John Wasik, doesn't seem to understand this referring to it as "The SEC's blunder."

He is magnanimous in allowing this to occur but includes some conditions or caveats to be placed on hedge funds. One of them is to include reporting performance net of fees -- which is already an industry standard.

I apologize for going back to the managed futures example but Mr. Wasik needs to read a basic CTA disclosure document, if he feels these guys don't reveal enough or are hiding the risks involved. Yes, exempt hedge funds don't have to provide D-Docs but most provide offering material and as I said, returns are reported net of fees.

He does point out that hedge funds will still only be available to accredited investors (people with a $1 million net worth not including primary residence, or an income of $200,000, $300,000 if married) but doesn't seem to know that many, if not most, hedge funds are restricted to the higher qualified eligible participant (QEP) standard of $5 million in net worth. He then criticizes the fact that the accredited investment threshold has not been adjusted for inflation since 1982; something the hedge fund industry supported itself, albeit as a compromise vs. general registration.

He notes: "Rather than stand their ground and demand honest disclosure about managers' abilities to beat the market after fees, the sheepish SEC opened the door to yet another round of investor deception."

Really. For the most part hedge funds can't go to investors, investors have to come to them, it has traditionally been part of the rules. As I have pointed out over the years, the hedge funds exemption requires them to not hold themselves out as investment advisors. It has always been disturbing to see the general business media criticize the secrecy of these products when the secrecy is written into the regulations that cover them. Why is this nowhere in this story?

Most disturbing about the whole Bloomberg BusinessWeek theme is that there is a tone of muckraking, like they're protecting the masses from the evil hedge fund universe, which by the way is only really available to the so called 1 percent, while what they really are doing is protecting the traditional mutual fund world that typically underperform their benchmarks, let alone provide alpha or diversification when things get bad.

By the way, it may be worthwhile to take a look at the advertisers in Bloomberg BusinessWeek. Perhaps lifting the ban on hedge fund advertising is a good thing for no other reason than it may prevent this type of biased coverage in the future.

2008 YALE INTERNATIONAL CENTER FOR FINANCE CTA STUDY

I would really like to get your feedback on the theme of this issue of BusinessWeek as well as the cover!