Look hard for a hedge fund that's a winner. Photographer: Munshi Ahmed/Bloomberg
Look hard for a hedge fund that's a winner. Photographer: Munshi Ahmed/Bloomberg

Larry Swedroe, research director for BAM Advisor Services LLC, noted earlier this month that total hedge fund assets under management, or AUM, reached $2.63 trillion. This represents a sizable increase, despite fund performance generously described as lackluster.

The increase in assets under management led to some interesting discussions. Lots of readers had e-mailed me with comments on both alpha -- market-beating returns -- and fee generation after last week’s column, ``The Hedge-Fund Manager Dilemma.''

There is much more nuance to the discussion of hedge funds than is widely understood. Today is a good time to review some of the related issues. Let’s see if we can clarify some misunderstandings:

Some hedge funds generate a lot of alpha: Given the underperformance of the industry, why do so many investors want to participate in hedge funds? The most likely answer is the enormous alpha generated by a handful of star managers.

Last week, this came up in an interview with Jim Chanos of Kynikos Associates (I’ll post a link when its released). Chanos started Kynikos in 1985, when there were only a few hundred hedge funds. The concentration of talent -- and alpha generation -- became the stuff of legend.

What has changed is the sheer number of funds and the amount of assets they manage. What hasn’t changed is the reality that the best performers capture a disproportionate amount of alpha. The 9,500 new me-too funds are not, according to the most recent data, keeping up with the top hundred funds. Indeed, they are not even keeping up with their benchmarks.

Beating the market is hard: This is obvious, but let’s give some context. Outperformance is a rare and elusive thing. Consistently outperforming in any given five-year period is harder still. Add in the standard 2 & 20 fee structure (a 2 percent management fee along with 20 percent of any gains) , and managers must overcome the enormous drag on returns. Net of fees and costs, we hunt for the rarest of creatures: Funds that earn their keep. It is no wonder that so few funds can meet that challenge. But the lure of outperformance is only one aspect of their appeal.

Cognitive bias and behavioral driven investing: Meir Statman, a professor at Santa Clara University in California, focuses on the cognitive errors that investors make.

In a 2011 interview, Statman noted that people want more than just returns from their investments. They are also looking for the “status and esteem of hedge funds,” he said. It isn't that different from “the warm glow and virtue of socially responsible funds” that send some investors in that direction. In both instances, performance takes a back seat to the emotional warm fuzzies investors feel. That feeling of belonging to a special club is why some high-net-worth investors are willing to pay up for mediocre performance. It grants them entrée to a sophisticated world they might not otherwise have.

We see this reflected in the mind share hedge funds occupy. Despite managing a relatively small percentage of total investable assets, they capture an unusual amount of media coverage. This may add to the overall mystique.

Selecting emerging managers: Experience has shown us this is an exceedingly difficult task. Beyond our own biases, it simply is a challenge to identify which managers will generate consistently good performance in the future.

The evolution of what happens to successful emerging funds helps to explain why. Some new managers identify unique alpha opportunities. These situations tend to be of modest size, perhaps a few billion dollars worth of market inefficiencies. Often, the emerging funds’ success attracts competitors, and the finite amount of alpha in that area gets fully mined. Very often, we see their success attracting lots of new capital, far in excess of what their niche can support and still generate market-beating returns. Sometimes, their success was simply random, a function of luck, and can't be repeated or duplicated.

Hence, we are faced with a situation where fees are high, outperformance is rare, and our own biases undercut our ability to select managers.

Note that we haven't gotten to the issues of hedging, market timing and stock selection. I plan on visiting these topic in a future discussion.

To contact the author of this article: Barry Ritholtz at britholtz3@bloomberg.net.

To contact the editor responsible for this article: James Greiff at jgreiff@bloomberg.net.