A free nation, not to mention free markets, depend on a free, independent press. How can voters make wise decisions—or investors allocate assets prudently—if the news they rely on is manipulated? Reporters struggle to inform their audiences, depending on sources for information while trying to avoid being played by those same sources. Day after day, countless unsung reporters succeed at this challenge, but failures occur. Perhaps the greatest recent embarrassment for free journalism was the Pentagon's "embedding" program in the early days of the Iraq invasion. With few exceptions, reporters willingly embedded with US military units. They played soldier, donning fatigues and digging fox holes to sleep in while breathlessly reporting the Bush Administration's propaganda on the evening news. Less spectacular, but equally disturbing, is the ease with which the financial press is manipulated into promoting questionable, risky or over-priced financial products. Readers of this blog know that the hedge fund industry is little more than a trillion dollar bait-and-switch scheme. Sadly, readers of the Wall Street Journal are not so well informed. In today's "Heard on the Street" column (perhaps it should be called "Played on the Street") journalist Gregory Zuckerman breathlessly tells readers that hedge funds, with a "few notable exceptions" are “storming back” from the summer's sub-prime meltdown. His column earnestly recounts how "some investors questioned whether juicy opportunities were a thing of the past," but hold on—Alleluia!—hedge funds are "pulling in more money than ever from investors." Before all the pension plan, endowment and foundation trustees who read Zuckerman's column race to hop on the newly revitalized hedge fund gravy train, I would like to ask a few questions about how carefully Zuckerman checked his facts. 1. Gregory, when you claim hedge funds "have seen $164 billion in new asset flows this year, already a record for a full year," you cite Hedge Fund Research, Inc (HFR) as your source. Did you double-check this claim with a less biased source? I doubt it, since I don't know of any less biased sources for such information. It is not like these numbers are compiled by one of the Federal Reserve Banks or something. The thousands of independent hedge funds are under no obligation to report their cash inflows to anyone, so they are free to reveal the information to only those industry organs that are most committed to hyping the industry. Other questions I have about the $164 billion number are whether it represents net inflows (inflows minus outflows) or just gross inflows? Does the number exclude investments hedge funds received from investors who pulled the money from other, troubled hedge funds? If so, what precautions were taken to exclude such investments? It is not as if hedge funds ask investors where the money came from, so how would they know? Does the number exclude investments the hedge funds receive from funds of funds reallocating their investments? Similar issues apply. Also, did HFR calculate the number by surveying every single hedge fund in the world (both domestic and overseas), or did they extrapolate the number from a survey of just a few (perhaps hand-picked) hedge funds? In a nutshell, I am asking, Gregory, just how manipulated is this $164 billion number? 2. When you talk about investors questioning if "juicy opportunities" were a thing of the past, did you ever stop to check if those purported juicy opportunities ever existed in the first place? I know that hedge fund marketing (in all its numerous guises, including planted newspaper stories) promotes the notion that hedge funds brilliantly produce outsized returns with low risk. I also know the industry compiles various hedge fund indexes that seem to substantiate those claims, but those indexes are compiled in ways that are known to be flawed. For example, you cite HFR in claiming hedge funds overall have returned 10.5% this year, easily outstripping the S&P 500, which has returned just 4%. Did you check to see if that 10.5% number included the staggering losses suffered by the two funds Bear Stearns had to shut down this summer? What about the $1.5 billion Sowood Capital lost before shutting down? How about all the other hedge funds that imploded following staggering losses on sub-prime debt or quantitative strategies? How many of their death spirals were included in the HFR Index you cite? I doubt any were, since it is entirely voluntary for hedge funds to report their results to HFR. Hedge funds that are outperforming the market are happy to report their success to HFR. Hedge funds that are hemorrhaging investors' money ... well, they are probably too busy struggling with other priorities to report their dismal numbers. If the numbers aren't reported to HFR, they aren't included in the HFR index, which means they aren't reflected in that 10.5% return number you cite. In summary, claims that hedge funds, as a class, consistently outperform the overall market (or otherwise offer "juicy opportunities") are unsubstantiated. The fact that hedge funds are under no obligation to consistently report their performance to anyone makes substantiating such claims difficult or impossible. If the hedge fund industry wanted to fix this problem, they could do so, but they choose not to. Perhaps, Gregory, you might refrain from speaking of the hedge fund industry's "juicy opportunities" as if they were fact. You might speak instead of their "claimed juicy opportunities" or "purported juicy opportunities." Journalistic integrity would seem to require as much. 3. I note that your column reports some bad news for hedge funds amidst all the good news. Interestingly, all the good news seems to originate with the hedge fund industry itself (HFR, hedge fund managers and fund of fund managers) while you cite actual investors as your source for most of the bad news. For example, you note that quantitative funds are still struggling, but you cite the sorry investors in those funds as your source for this information. I am wondering if you might want to dig a little deeper—or maybe a lot deeper. How much else does the hedge fund industry choose not to tell us that a more systematic survey of actual investors might? There may be a story here. 4. Finally, are you familiar with the oldest trick in the investment management industry? You launch ten funds, see which ones perform best in the first year; promote those funds; and quietly close the rest. This takes various guises and has various names. These include "survivor bias" and "promote the winners." If I stuck 10,000 monkeys in a stadium and had each flip a coin ten times, about ten of those monkeys would get ten heads in a row. Would you consider the names of those ten or so star monkeys newsworthy? Would you write a column documenting their amazing accomplishment? If not, why are you reporting on the few hedge funds that "won bets they made against financial companies and lower-rated slices of debt" or the lucky funds that are "scoring from big moves in oil, gold, currencies and emerging markets." This isn't news. As with my example of 10,000 monkeys, in any given market environment, there will be a few out of the 10,000 or so hedge funds that happen to profit from that environment. This is the law of large numbers. It applies to monkeys as well as hedge funds. It is irrelevant. The last decade has witnessed a litany of hedge fund failures. Evidence that hedge fund managers provide sophisticated trading strategies for their bloated fees is hard to find. It appears that the hedge funds that choked on sub-prime this summer were just blindly investing in sub-prime—no sophisticated timing models or rocket science hedges—just plain, dumb, leveraged long sub-prime investing. Quantitative funds are really just warmed over, leveraged technical analysis—sometimes they win; right now, they are losing. There is enough scathing evidence against the hedge fund industry to get every last investor out. But that is not what happens. The industry's marketing machine papers over the problems with dubious statistics and never-ending talk of juicy opportunities. I am reminded of how Dick Cheney, without perhaps explicitly lying, kept mentioning Saddam Hussein and al Qaeda in the same sentence, over and over and over again. Juicy opportunities, juicy opportunities, juicy opportunities, juicy opportunities ... and journalists jump in to offer the credibility that makes this sales pitch fly. Gregory: pension fund, endowment and foundation trustees rely on you to inform their investment decisions. Those decisions will impact millions of retirees and students, not to mention the thousands of charities that depend on foundation money. You have a profound responsibility to this multitude. Glyn A. Holton
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