THE BLOG
12/22/2012 08:22 pm ET Updated Feb 21, 2013

For Hedge Funds, It's All in the Game

There are few greater examples of the irrationality of investors than the world of hedge funds. Hedge fund managers are paid enormous sums, usually 2 percent of the investment amount and 20 percent of profits above a fixed level. As money has poured into these funds over time, hedge fund managers and others working in the industry have become fabulously wealthy. But, now, here's the rub, the investors haven't benefited. In fact, hedge fund investments have consistently performed substantially worse than basic investments in low-fee equity index funds, exchange traded funds or a simple mix of equity and bond funds.

I am an outsider to the world of hedge funds in that I neither work nor invest in hedge funds. Without an ounce of insincerity, I can state that I don't understand how this industry survives, let alone has thrived for so long. Hedge funds are not generally open to average investors, but rather receive their funding from institutional investors (the source of roughly two-thirds of hedge funds' assets) and people categorized as sophisticated investors (presumably wealthy individuals with investing knowledge/experience).

Those investing in hedge funds are generally not naïve to the fact that these funds, on average, provide much lower returns than equity indexes. Moreover, investors generally are aware that the lower returns are due to the high fees that the hedge fund managers extract from investors. Yet, in spite of the historically poor return on investment, money continues pouring into hedge funds -- they currently manage $2.2 trillion in assets or roughly four times more than in 2000.

So why would a class of investors who are well-aware of investment options, strategies, risks and expected returns continue to plow money into hedge funds, knowing they have a comparatively low rate of return? I posed this question to some contacts in the industry. A consistent reply was of the form, "Yes, on average hedge funds aren't a good investment compared to index funds, but if you do your research you can find hedge funds that have great returns at relatively low risk." Of course, this logic works for any stock picking, selecting of mutual funds or, for that matter, horse racing, football games or any other type of gambling. It is a well-established fact that very few traders or mutual funds have seen consistent year-over-year returns on investment above market performance. In fact, last year's most successful performer is often the laggard the next (due to reversion to the mean).

One reply I received during a conversation with a hedge fund employee was that "by diversifying across many classes of investments, including hedge funds, the investor's average return for their portfolio is expected to be higher even if hedge funds tend to drop down the average." When I pushed that theoretical explanation to the real world by asking, "but if I had diversified my portfolio 10 years ago so I had a basket of hedge funds included in my current mix of stocks and mutual funds, on average wouldn't I have less money now?" the answer was a sheepish, "Yes, you would less money if you had diversified into hedge funds because of the hedge fund manager's fees." I followed up by asking, "since the fee structure is a primary reason why the investor isn't getting a higher return on investment, why don't hedge funds make themselves more appealing to investors by competing on fees. After all, don't institutional investors complain about what seems like collusion?" He smiled at me and then quoted The Wire by stating, "It's all in the game, brother. It's all in the game."

Since return on investment is clearly not the main reason for the ongoing popularity of hedge funds, one has to wonder what else is driving the ongoing appeal? Is it that investors are swayed by smooth sales pitches where hedges funds tout their extensive collection of Ph.D.'s busy combing the data to find market inefficiencies? Is it the exclusivity factor, where the appeal is based on the fact that average investors like myself cannot join the hedge fund investor club? Are institutional investors and hedge funds are so tightly linked that the fact that the institutional investor's clients aren't benefiting from hedge funds has become irrelevant?

A popular stock market cliché is that that market is short-term irrational but long term rational. If that is truly the case, then in the long term we should either see hedge fund manager's fees drop dramatically so that investor's return on hedge fund investments increases or a major drop in the percent of investor's money going into hedge funds. Until that day happens, it is difficult for me to watch Squawk Box without thinking of Omar Little, Maury Levy and the rest of The Wire.