July 16, 2015—Hedge funds present hazards for many and the highest rewards for a relatively small segment of investors, said Leon M. Metzger, an industry expert and former fund executive who teaches at New York University’s Leonard N. Stern School of Business. The fortunate investors find a manager who has sound judgment along with the stomach for risk.
Metzger discussed the industry in a presentation to economists and other staff at Nathan Associates, as part of the firm’s speaker series, “Economists Present.” Hedge funds are largely unregulated pools generally for people or institutions—including pension funds—with at least $1 million to invest. The funds seek higher returns than stocks or bonds and may do so by betting large amounts of borrowed money on changes in the value of various assets.
The funds can and do beat such benchmarks as the Standard & Poor’s 500 Index of stocks, but investors should read the performance data with caution. For instance, some gauges of hedge fund performance don’t adequately screen out phenomena that may skew data. Firms might not report on performance until results are strong, or the indexes count only the successful firms because poor performers have left. A moribund firm may stop reporting for the index.
Moreover, according to Metzger, data comparing hedge fund performance with the S&P 500 show “you’re not going to do well” unless invested in the top 10 percent to 15 percent of hedge funds.
Assessing the risk of hedge funds is difficult because a standard tool, volatility, is of questionable value though widely used. A risk-return analysis may favor hedge funds, but is that analysis appropriate if it means that the hedge fund investment has “a high probability of a small profit and a small probability of an extreme loss?”
“There is no single appropriate metric for risk,” Metzger said, warning that predictive models may not work well in reality. “What’s most important is judgment.”
Despite the many cautions, funds have their upside, especially for investors who land in the top 10 percent of funds and have access to experts. Markets don’t always rise, and hedge funds can profit from market declines. Some funds offer diversification, and the better-performing ones can help pensions meet their targets.
Metzger was vice chairman and chief administrative officer at the fund-management company Paloma Partners Management Co. for 18 years. In addition to teaching, he testifies as an expert witness in financial litigation and other disputes.