Academic studies for many years have demonstrated over and over again how difficult it is for active managers to consistently beat the market. Most of these studies show that about 65 to 70% of the time active managers fail to beat market averages.

I recently read the 2011 edition of Burton Malkiel’s classic book on investing called ” A Random Walk Down Wall Street”. Originally published in 1973, it has been updated nine different times. It is chock full of  history, wisdom, academic studies, and also has a lot of humor. In his book he states ” That through the past 30 years more than two thirds of professional portfolio managers have been out performed by the S&P 500 Index”.

With all the evidence from numerous academic studies dating all the way back to 1900 showing the superiority of passive investing, why don’t more people use this strategy? As Princeton professor Burton Malkiel explains in his book, ” It’s hard for people to accept because it’s like telling someone there is no Santa Claus, and people don’t like to believe that.”

Being a little cynical, and having had a six year stint on the dark side as a stockbroker way back in my past from 1968 to 1974, I think the conflict of interest of stockbrokers selling the latest hot performing managed mutual fund to earn a commission is another reason why investors are convinced. Never underestimate the power of Wall Street’s marketing machine.

Have things changed recently? Not really. A recent article in the February 4-5 weekend edition of the Wall Street Journal by Ben Levishon, pointed out that mutual fund managers had a miserable 2011. He stated that ” Last year, just 23% beat their relative benchmark, according to investment research firm Moringstar – their worst record in at least 10 years. A record like that could drive many investors out of actively managed funds and into funds that merely track an index” I agree Ben.

Maybe the answer is to move up a notch and choose a hedge fund, instead of an actively managed mutual fund. After all hedge funds are managed by Wall Street’s best and brightest money managers. True, you have to pay an arm and leg with the typical management fee being 2% annually, and 20% of the profits. But isn’t this just a case of getting what you pay for? Not according to Simon Lack my former colleague at JP Morgan Chase.

Simon wrote a book called ” The Hedge Fund Mirage: The Illusion of Big Money and Why It’s To Good to Be True” It is a very recent book published in January 2012. This book has been garnering a lot of attention in the financial press with reviews by the Wall Street Journal, The Economist, Forbes, Bloomberg, and others. He has had extensive experience in dealing with hedge funds. Much of Lack’s career was spent in North American fixed income derivatives and forward FX trading both as a trader and as a manager. He also sat on JP Morgan’s investment committee which allocated over a $ 1 billion to hedge fund managers.

A January 7th article in the Economist on Simon’s book stated ” There is no doubt that hedge fund managers have been good at making money for themselves. Many of America’s recently minted billionaires grew rich from hedge clippings. But as a new book by Simon Lack, who spent many years studying hedge funds at JP Morgan, points out it is hard to think of any clients that have became rich investing in hedge funds. Indeed since 1998, the effective return to hedge fund clients has only been 2.1% a year, half the return they could have achieved by investing in boring old treasury bills”

Another article on Simon Lack’s book in Forbes magazine’s Personal Finance column discussed some other interesting points. They stated that  Lack was an industry insider, having spent part of his career at JP Morgan helping to allocate more than $ 1 billion to hedge funds and seed emerging hedge fund managers. Immersed in the industry, he eventually came to the conclusion that: ” While the hedge fund industry has generated fabulous wealth and created many fortunes, it has largely done so for itself ” This article also points out that  during the 1998 – 2010 time frame the HFR Global Hedge Fund Index puts the industry’s annualized return at 7.3%. In Lack’s mind, those return figures are distorted by several factors. So Simon performs his own asset weighted calculations (similar to the internal rate of return methodology of measuring private equity or real estate fund performance) using Barclay Hedge data to measure how the average investor, as distinct from the average fund, has done.

His conclusion: ” from 1998-2010 the index returned only 2.1% annualized on a money weighted basis, not 7.3%. During that time frame, he estimates that hedge fund managers earned $379 Billion in fees, while real investors earned only $70 billion in profits. Thus, the operators earned 84% of the investment profits and investors only 16%. Those figures don’t account for funds of funds which add another layer of fees. Funds of funds account for about one third of hedge fund purchases. He estimates that this brings the industry fees up to $440 billion, or a whopping 98% of the profit pool, leaving only $9 billion for investors.”

Whether one agrees with all of  Simon Lack’s conclusions and the math in his book, the points he raises should give pause to investors who think that hedge funds are the answer to getting great returns. Simon has some company in his conclusions. In 2010 two academics, Ilia Dichev from Goizueta Business School at Emory University and Gwen Yu from Harvard Business School, published a research paper titled ” Higher Risks, Lower Returns: What Hedge Fund Investors Really Earn” This study went back to 1980 and performed a very detailed analysis. It concluded that overall industry returns have been a disappointment for hedge fund investors.

I think this a very big example of “Costs Matter”. While there have been some big winners among hedge fund investors, overall the majority of investors have found themselves on the short end of the stick. Just another example of how hard it is to find active managers who can consistently outsmart the market over the long term.

Some things change, Some things don’t.

Pat Manning