Should You Be in Hedge Funds and Private Equity?

Most of us have all had a similar experience. Maybe it was back in the 80s, when leveraged buyout funds first made their appearance. Maybe it was back in the 90s, when everyone wanted a piece of the venture capital action. Or maybe it was at a party last weekend, when cousin Charlie was waxing eloquent about how he's in both “hedge fund” and “private equity” today. “And why aren't you?” he's bound to ask. If you've been wondering how to reply to that question, this article is for you.

Let's start with some basic definitions. At the highest level, both a “hedge fund” and a “private equity” fund are privately organized pools of capital run by a professional investment manager. At last count, there were about 10,000 hedge funds managing $1 trillion in investor funds, and 3,000 private equity funds, managing about $700 billion in assets. Of the latter, about $490 billion was invested in “buyout funds”, and $210 billion in “venture capital” funds.

One of the most important features of these funds is that they are not cheap to own. In order to attract the best active managers, a typical hedge or private equity fund charges investors an annual fee equal to two percent of assets, and pays twenty percent of all returns (above a certain amount) to the fund manager. In order to justify these fees, hedge and private equity funds often make two promises to their investors. First, that their returns will be high, and second that they will have a low correlation to the returns on other asset classes. Let's begin by taking a closer look at how these funds theoretically generate the high returns they promise.

We'll begin by noting that since both hedge funds and private equity funds are actively managed products, their superior returns ultimately must be grounded in the ability of a skilled manager to make a superior forecast, in comparison to his or her competitors. In turn, these forecasts must be based on some combination of superior information and/or a superior model for making sense of the public and private information available to the fund manager.

“Hedge Funds” are not a separate asset class, per se. Rather, they are a collection of diverse investment strategies that are applied in different asset classes (e.g., bonds, equity, commodities, etc.). These investment strategies broadly fall into three categories. “Statistical Arbitrage” managers start by calculating the statistical relationship between different types of assets. When those relationships depart from historical norms, these managers attempt to profit by acquiring (“going long”) the asset that they believe to be underpriced, while selling (“going short”) an equal amount of the asset they believe to be overpriced. When the underlying relationship returns to its historical norm, the arbitrage manager reverses these trades to realize his or her profit. Because these price differences are typically quite small, Arbitrage funds typically use large amounts of leverage (i.e., debt) on top of their investors' funds to magnify them. Provided asset prices return to their long-term relationship, the Statistical Arbitrage strategy can make attractive returns. However, if these price relationships remain out of line - or worse, get even more out of line - then Statistical Arbitrage strategies can lose very large amounts of money, very quickly. Just ask anyone who invested in Long Term Capital Management, and watched it blow up (and almost take down the banking system with it) in 1998.

Now what about the argument that arbitrage funds have a low correlation to returns on other asset classes? As long as the statistical relationships don't get too far out of line with their historical norms, the low correlation argument probably holds. However, when they get significantly out of line, it is probably because significant negative events are also taking place in other asset classes. When these events occur (e.g., the Russian debt default in 1998 that caused the spread between emerging markets debt and U.S. Treasury Bonds to dramatically widen), they will typically cause the correlation between the statistical arbitrage strategy and some asset class returns (e.g., high yield and emerging markets debt) to sharply increase.

“Directional” hedge fund seek to make profits by going long assets they have concluded are undervalued, and/or short assets they believe to be overvalued. These long and short positions could be in different asset classes (in the case of “Global Macro” funds), in one asset class (e.g., “Equity Long/Short” or “Emerging Markets” funds) or in different securities issued by companies subject to unusual events (e.g., “Event Based” or “Merger Arbitrage” funds). The hedge fund manager's valuation of these securities is typically based on some combination of fundamental analysis of the expected cash flows and risks from the assets themselves, or analysis of the expected future moves of other investors. The long and short positions are typically not offsetting; hence a directional manager has a “net long” or “net short” exposure, that tends to be correlated with the returns on the relevant asset classes. Obviously, making the wrong valuation judgment causes a Directional manager to lose money. The actual amount of money lost, however, depends on what the hedge fund has been investing in. For example, a quarter percent change in interest rates has a lot bigger impact on the value of a long-term bond than it does on the value of a short-term bond. In this example, the hedge fund manager can magnify the potential return on her interest rate forecast by changing the maturity of the bonds he or she holds. Moreover, the actual “directional bet” may itself not be a symmetrical one. For example, consider a hedge fund that invests in catastrophe bonds. These are typically issued by companies that provide insurance against low probability, but high cost events (e.g., like a hurricane). If the specified event does not occur within a given period, the bondholders receive their principal back, plus a very attractive return. However, if the event occurs, and is sufficiently costly to the insurance company, the bondholders may lose their principal. In this case, on the upside, if our Directional hedge fund manager's hurricane forecast is accurate, he and his investors will make a nice return. However, if his forecast is wrong, the downside losses can be much larger.

Finally, “Market Neutral” strategies are based on the difference between systematic risk, which is common to all securities in an asset class, and company-specific risk. A Market Neutral manager seeks to profit from his or her superior ability to analyze company-specific risk, without taking systematic (also known as “beta”) risk. For example, an equity market neutral manager might invest $100 each in ten companies, while selling short a $1,000 of equity index exchange traded funds. The net return on this investment would be pure “alpha” - that is, return for taking company specific, rather than market risk. In theory, it should also be uncorrelated with the return on the underlying asset class. In practice, however, the relationship between systematic and company-specific risk is not as cut and dried as it is in theory. For example, consider an investment in a company that improves its operations to the point that it shifts from being included in a value sub-index to membership in the market's growth sub-index, at the same time that the balance of investor sentiment shifts from favoring value to favoring growth. Clearly, the return realized by a hedge fund manager who owns this stock will contain elements that are both company-specific and systematic. In short, in practice it is very hard to be perfectly equity market neutral (see, for example, “Are Market Neutral Hedge Funds Really Market Neutral?” by Andrew Patton).

One more point needs to be made, which applies to all hedge fund styles. As more money has been invested in hedge funds, the logical question to ask is how managers will seek to match their past returns in a much more competitive environment. Two answers present themselves, and neither is reassuring. The first is to make investments that involve more risk. The second is to employ more leverage to magnify the impact of declining “basic” returns. Both raise the chances of experiencing serious losses, unless an investor carefully controls his or her risk exposure.

Broadly speaking, there are two types of private equity funds. Venture capital funds invest in small companies during the early stages of their growth. Buyout funds invest in companies that are larger and have longer track records. Let's look more closely at these two return generating processes.

In their earliest stages, new companies typically obtain their financing from “F, F+F” - founders, families and friends. Venture capital funds only get involved when a company has progressed beyond this stage. Their investments are typically in the form of some type of equity (e.g., convertible preferred shares), and the companies they finance typically do not use much debt. Within our active management framework, venture capital managers hope to earn superior returns through a combination of superior information or a superior model. The former can involve superior insights into the future market for a technology, other investors' future view of companies operating in certain areas, and/or superior access to potential investments (e.g., due to a superior network or a superior brand image in the venture community). A superior model can include the venture capital firm's approach to adding value to an company in which it has invested (e.g., by helping to put together a superior management team, or bringing to bare a superior ability to manage rapid growth) or its superior ability to generate value from all the companies in its portfolio (e.g., by finding ways for them to work together). Venture capital funds realize the value of their investments through two means: by selling them to other companies (“trade sales”) and by selling them to the public (“initial public offerings”). The pricing on these sales obviously depends on prevailing equity market conditions; hence the correlation between venture capital and public equity market returns should theoretically be quite high.

The return generating process for a buyout fund has some similarities with venture capital, but also some important differences. Buyout funds typically invest in three types of deals: divisions being sold by another company; privately owned companies whose owners are cashing out, and public companies that are going private (i.e., where the buyout fund purchases all the target company's publicly traded shares, and de-lists it from a securities exchange). Ideally, buyout fund managers generate value for their investors through proprietary access to potential deals. However, an increasing number of deals are being sold to buyout companies via competitive auctions, so as to maximize the value realized by the seller. This has led many buyout funds to either shift their focus to markets in which they can still generate proprietary deal flow (e.g., Europe and Asia), and toward increased industry specialization, which may also yield reduced competition for deals.

Given this, the theoretical source of buyout funds' superior returns must be either other forms of superior insight and/or superior models. The former can include superior insight into future equity market trends and/or investors' preferences for companies in different sectors, or a superior model for improving an acquired company's business. The nature of the latter has been the subject of much discussion over the years. In the 1980s (when this writer was doing buyouts), the superior model was essentially based on three insights. First, many public companies were run inefficiently, with substantial room to increase cash flow by cutting costs and selling non-core assets. Second, the resulting increase in operating cash flow could be used to add more leverage to the company's balance sheet that had been used in the past, which would magnify the return on its equity. And third, too many managers lacked a sufficient equity stake in their own company.

Today, the buyout business has fundamentally changed, and theoretically become more difficult. The twin pressure of global competition and demanding shareholders have forced many public companies to become much more efficient, and much less reluctant to add leverage to their balance sheets. In addition, most senior managers today are eligible for substantial amounts of incentive linked pay. This has forced buyout funds to identify new ways of improving the operations of the companies they acquire. This logically leads to the question of what obstacles prevented these steps from being taken before these companies were acquired by the buyout fund. To be sure, there are reasonable answers to this question. In some cases, an acquired non-core division of a public company lacked access to the corporate funds needed to execute its strategy. In other cases, a family owned company might have been reluctant to take the risk associated with a more aggressive strategy. The same might have been true of the management of a public company with respect to adoption of a strategy that would have put quarterly earnings targets at risk. Or perhaps being privately owned, with clear demanding leadership from the top, improves overall execution of an already promising strategy. Whatever the logic, one thing seems clear: value creation by buyout funds is more difficult today than it was in the past.

Perhaps the best evidence for this is the change in the way that buyout funds realize the value of their investments. Traditionally this was done through either trade sales or initial public offerings, both of which generated a high correlation with returns on the domestic equity market. Today, however, buyout funds use two additional approaches to obtain cash to return to their investors. The first is sales to other buyout funds. If this raises some eyebrows (e.g., “what does the second buyout fund know that the first one didn't?”), the second approach should ring some alarm bells. This is the practice of releveraging a portfolio company to raised funds that are used to pay a special dividend to the buyout fund.

The obvious question is who is lending the money for these “leveraged recapitalizations?” The answer lies in the way the fundamental operation of debt markets has changed in recent years. In the old days (and you don't know how much it pains me to write that), buyouts were often financed with a combination of bank loans and what were then known as “junk” bonds. These are the same below-investment grade bonds that have since gone upmarket, and are now known as “high yield debt.” In those days, bank loans tended to stay on bank balance sheets. One bank would arrange the loan, and syndicate pieces of it out to other banks, which would share in some of the arrangement fees. The junk bonds would also tend to stay in one place, though for a price some investment banks (e.g., Drexel) make secondary markets in them. Since these credits staid in one place, the people who approved them tended to be a bit more careful with their credit analysis, and reluctant to see deals “leveraged to the moon.” Because we all knew who would end up holding the hot potato if the economy headed south.

Today, nobody is quite sure who is holding that potato. Banks now view “leveraged loans” (i.e., loans to highly indebted companies) as a trading asset. They underwrite them, and then sell them to a variety of new entities that have arrived on the scene. The first is mutual funds that invest in loans. The second is sometimes hedge funds and other institutional loan investors. But the third is the most interesting. These are the special purpose vehicles that use the same basic structure popularized two decades ago in the mortgage market by Salomon's Lou Ranieri. These vehicles buy loans, and then issue different classes of security based on the loan cash flows. These securities are known as “collateralized debt obligations”. Each CDO class has a different risk/return profile. The most senior security might carry a AAA rating. The next class might be subordinated, and carry a below-investment grade rating. And at the bottom there is a so-called “equity tranche” that earns high returns if everything goes right, and gets very badly hurt if things go wrong. In many deals, there is a parallel structure with respect to the bonds issued by the company owned by the buyout fund. When you think it through, the key to these leveraged recapitalizations is the buyer of the CDO equity tranche. Who are they? Who would take this kind of a risk? If you guessed hedge funds, the betting line is that you are right on target. Now why might they so like CDO equity tranche deals?

As we've already mentioned with respect to catastrophe bonds, these deals offer very high returns as long as everything goes right. That's undoubtedly reason number one. But reason number two is probably due to another interesting development: the birth and rapid growth of a derivative market for trading credit risk. Credit default swaps (and options on them) theoretically enable the owner of a CDO equity tranche to manage his or her fund's exposure to the underlying credit risk by purchasing insurance in what is assumed to be a liquid derivative market. So far, so good. Except for one nagging question: who is on the other side of those credit derivative trades? Some people say it's mostly hedge funds. Others say a lot of banks are involved too. One thing is for sure: the credit risk didn't disappear. A lot of people also wonder about how much leverage is being used by those institutions who are holding it, either in the form of CDO equity tranches they have bought or credit derivative contracts they have sold. But the most interesting part is that nobody really knows the answer to these questions. So while few doubt that a lot of heavily leveraged companies that have been “recapitalized” by buyout funds will eventually run into problems, the really interesting question is the nature of the overall impact on the system that will be triggered when they do.

Some very smart people are worried about this. For example, in their recent paper “Systematic Risk and Hedge Funds,” Chan, Getmansky, Haas and Lo conclude that “the hedge fund industry may be heading into a challenging period of lower expected returns, and that systematic risk is currently on the rise.” Similarly, in its March, 2005 Quarterly Review (“Time Varying Risk Exposures and Leverage in Hedge Funds”), the Bank for International Settlements concluded that “painting a comprehensive picture of the hedge fund industry is virtually impossible given the data available.” It also found that “hedge funds that reportedly belong to different style families, and thus presumably follow different investment strategies, have at least some commonality in their risk exposures.” Moreover, “to the extent that hedge funds engage in investments that have payoffs that resemble derivative instruments, their returns will be non-linearly related to the returns on the underlying market risk factors.”

Let's now move on to another point that is too often overlooked in the excitement over the prospective returns from investing in hedge funds and private equity (which remind us of Charles Revson's comment about the cosmetics business: “we're selling hope.”). Most studies show that in the world of hedge, buyout, and venture capital funds, the difference between top and bottom quartile managers' returns is quite large. This is taken as evidence of “inefficiency,” or substantial differences in managers' skill and access to information. However, even in inefficient markets, alpha is still a zero sum game. This is an important point that investors too often overlook. Mathematically, there is a weighted-average return from investing in the universe of all hedge, buyout, or venture capital funds, that is ultimately related to the amount of systematic (i.e., beta) risk they bear. In any year, some funds will deliver returns above this average (generating positive alpha) while others will deliver returns below it (negative alpha).

Investors in hedge, buyout and venture capital funds face the same challenges as investors in actively managed mutual funds: How to identify truly skilled investment managers? And how to be sure that these managers will not capture (via fees and expenses) all the alpha they create? As you know, this implies a successful forecast on the part of the investor choosing from multiple hedge, buyout and venture capital fund managers. And any manager selection forecasting skill necessarily depends on the investor having either superior information and/or a superior model. Paying an investment consultant (or, alternatively, a “fund of fund” manager, which makes sub-investments in a number of hedge, buyout, or venture capital funds) to make this choice only changes the nature of the forecasting problem (while making it more expensive for the investor). However, the forecasting problem does not go away.

If there is any good news, it is that in the world of hedge and private equity funds, (and unlike the world of mutual funds), past performance may be a useful guide to future results. For example, in “The Life Cycle of Hedge Funds”, Mila Getmansky found that for most hedge fund categories, performance increased with size, but at a decreasing rate. One reason for this is provided in the paper “Analyst Industry Diversification and Earnings Forecast Accuracy” by Dunn and Nathan. They found that as analysts covered a broader range of industries, their forecasting accuracy declined. To put it differently, what has been called the “fundamental law of active management” states that alpha is a function of forecasting skill times the number of opportunities for its application. Dunn and Nathan's findings suggest that this may need to be modified, given the apparent negative relationship between these two variables (a point that is also consistent with many findings from cognitive psychology research). In other words, while big and successful funds may benefit from better access to deal flow, increased size may actually cause their forecasting skills to weaken.

Further evidence for this is found in the paper, “Private Equity Performance: Returns, Persistence, and Capital Flows”, by Kaplan and Schoar. They found that managers of previously successful funds were more likely to raise follow-on funds, and to earn above average returns. They hypothesize that this is due to proprietary deal flow and differentiated fund manager skill. They also found that new funds started during cyclical booms were the ones most likely to earn low returns (probably because booms attract marginal or unskilled managers into the hedge and private equity funds business).

To answer the second question - the probability of earning risk adjusted returns (after those hefty manager fees) greater than those available in publicly traded asset classes - we must turn to the thorny question of how to measure hedge and private equity fund performance.

The first issue is the level at which the analysis is being done. Conceptually, this can occur at the level of portfolio companies, the individual funds, or the aggregated results for all hedge, buyout, or venture capital funds. Each level of analysis produces its own insights. For example, in his paper “The Reality of IPO Backed Performance”, Yochanan Shachmurove analyzed the returns realized on 2,895 venture-backed public companies between 1968 and 1998. This sample is itself somewhat skewed, because perhaps only 20% of the companies in which venture funds invest ever make it to the public markets. The following table shows average and median nominal returns, as well as return breakpoints and standard deviations for both companies that were still trading in 1998, and those that were inactive (due to bankruptcy or having been acquired).

As Shachmurove notes, “while the media focused on a few big IPO success stories, rather than being typical they were highly unusual in the historical context.” Others have noted that venture capital funds in essence invest in a portfolio of options, since most of their investments fail, while a few deliver sometimes spectacular returns.

The aggregate indexes for hedge, buyout and venture capital fund performance all suffer from substantial shortcomings. The first is the so-called “self-selection bias.” This refers to the fact that funds report their returns voluntarily. Logically, this probably biases the results towards the more successful funds. This problem is compounded in the hedge fund world, where funds report to different competing index providers (in the private equity world, the problem seems less severe, with Venture Economics having a substantial market share).

The second problem is known as the “backfill bias.” This refers to the fact that when a fund joins an index, it provides a year or two of previous returns. Research has shown that subsequent results are almost always lower. Hence, if backfilled data are included, index average returns will be biased upwards.

The third problem is the “survivorship bias.” This refers to a situation in which funds that merge, close, or stop reporting have their results dropped from the index. Again, this biases returns upward, and risk downward.

The fourth problem is the “stale pricing bias.” When the reported price of an infrequently traded security is determined not by a market transaction, but rather by an appraisal (often by the fund manager), a number of distortions typically result. First, the returns on the security (and of the fund itself) display a higher correlation over time than is the case with most publicly traded securities. Second, this causes reported standard deviations to appear artificially low. It also artificially depresses the reported correlation of return with other asset classes. (For more information on these biases, see “Do Hedge Funds Hedge?” by Asness, Krail, and Liew, and “Asset Allocation Effects of Adjusting Alternative Assets for Stale Pricing” by Andrew Connor).

The fifth problem is known as “style drift.” Particularly in the case of hedge funds, researchers have found that a hedge fund's self-categorization of its investment strategy (e.g., Equity Market Neutral), when regressed against different asset class returns, shows that another approach is being used (e.g., equity long/short, which entails substantial systematic risk exposure).

A number of index providers have attempted to eliminate some, if not all of these biases. For example, the value weighted CSFB/Tremont Hedge Fund Indexes do not allow backfill data, and they are corrected for survivorship bias. Over the 1994-2004 period, the real returns on this index (and on two key sub-style indexes) are as follows:

We include Equity Market Neutral and Global Macro in this table because they are based on two clear strategies for generating alpha: security selection (in the case of EMN), and asset class timing (in the case of GM). Their correlation with each other is .43. As you can see, the two hedge fund styles, plus the overall index, have historically delivered attractive aggregate returns per unit of risk, as measure by standard deviation (volatility). You can also see that at this aggregate level, the distributions of hedge fund returns are close to normal. Skewness refers to whether the distribution is tilted to the left (negative skew, or annual returns below the average more likely) or right (positive skew). A skew greater than .5 or less than (.5) is considered a significant departure from normality. Kurtosis measures the extent to which more returns are located in the tails of the distribution (i.e., at either extreme) relative to a normal distribution. A positive kurtosis value implies a higher than normal percentage of extreme annual returns. Kurtosis of more than 1.0 or less than (1.0) is considered a significant departure from normality.

However, we stress that these figures are aggregates for a given hedge fund style. At the level of an individual hedge fund, annual returns can be (and often are) very non-normally distributed. What this table says is that when these funds are combined, their returns come close to a normal distribution with attractive risk and return characteristics.

On the private equity side, many writers have tried to adjust for the aforementioned data problems, to produce a clear picture of the performance of buyout and venture capital funds. Kaplan and Schoar found that between 1980 and 2001, the adjusted return and risk on buyout funds (after manager fees) was essentially equal to that on the public equity market. Their index of venture funds returns delivered about 3.5% more than the public equity market, with about 14% more standard deviation. Susan Woodward of Sand Hill Econometrics has done a similar analysis, and published her findings in “Measuring Risk and Performance of Private Equity.” She also finds that buyout returns are about as risky as the public equity market, and are also highly correlated with it. In contrast, venture capital was about twice as risky as the public equity market, but its returns were also highly correlated with it, just as theory would suggest. Regarding those returns, the Venture Economics database shows that, over the 20 years ending in December 2004, aggregate venture capital fund investments outperformed the S&P 500 by only 4.0% per year.

This raises an obvious question: Can you invest in a hedge fund or private equity index product?

Many hedge, buyout, and venture capital funds are organized as limited partnerships, with the investment manager as the general partner. These LP investments are generally only available to “qualified” investors”, who can produce evidence of a minimum level of income or net worth. In addition, the minimum investment in a hedge or private equity partnership has traditionally been quite large. However, in recent years these have been falling. For example, some partnerships now accept minimum investments of $25,000. Even smaller minimums are often available if the investment advisors, who combine different people's contributions to reach the LP's minimum investment. In addition, in a few cases, private equity funds have been organized as either publicly traded closed end funds (e.g., Apollo Investments or Ares Capital in the United States), or individual companies (Onex in Canada, 3i in the U.K., or RHJ International on the Euronext in Brussels).

Similarly, a growing number of closed end and even open ended mutual funds (OEICs or unit trusts in Europe) now claim to be using “hedge fund-like” strategies to manage their investments (e.g., Hussman Strategic Growth Fund and the Pimco All Asset Fund in the United States, which are similar to equity market neutral and global macro hedge funds). Retail hedge funds are available in some countries. A good example of this is the Tremont Capital Opportunity Trust in Canada (TT.UN), which invests in a broad mix of underlying hedge fund strategies. However, these funds of funds are not cheap; the Tremont's expenses are on the order of 3.0% per year. This has created an opportunity for the introduction of lower cost products that track hedge fund indexes. One example of a hedge fund index product in the United States is the RYDEX Sphinx fund (which has a $25,000 minimum). Another example, Rydex' Structured Beta Funds, is discussed in this month's product and strategy notes. Elsewhere, in many countries CSFB offers similar products that track the CSFB/Tremont investable hedge fund indexes. And in Germany, Hansainvest has recently launched an index fund that tracks the MSCI HedgeInvest Index.

Finally, in some countries, equity linked debt instruments also have been issued which promise return of principle, plus payments that are tied to the return on a hedge fund interest. A good example of these is a note issued by Societe Generale Bank in Canada, and the Isle of Man, whose return is tied to the MSCI Hedge Invest Index. Rabobank has launched a similar product in Europe. To our knowledge, there are no investable products based on a buyout, venture capital, or combined private equity index.

However, the performance so far of investable hedge fund index products confirms the problem of fund returns declining with size that was first raised in the theoretical literature. Since these index products invest in relatively large underlying hedge funds, their performance has tended to lag that of the broad hedge fund index, which contains a large number of smaller funds. For example, the year to date nominal return through June, 2005 on the CSFB/Tremont Hedge Fund Index was 1.34% (in U.S. dollars), while the return on the MSCI HedgeInvest Index was .17%, while the return on the Standard and Poor's Hedge Fund Index (SPHINX) was .13%, and the CSFB Tremont Investable Hedge Fund Index was up .19%.

So where does this leave us? Should you invest in hedge funds, buyouts, and/or venture capital? When it comes to buyout funds, we think that the answer should be “No.” Absent superior skill in forecasting future buyout manager performance, an investor on average is likely to only earn a risk adjusted rate of return comparable to public market equity. More importantly, given the large difference between the returns on top buyout funds versus all the others, an unskilled investor is likely to do worse than he or she would have with an equity index fund.

Venture capital does not present an equally clear answer. Given the high correlation of venture capital returns with public equity markets, its logical role in a portfolio seems to be that of a return enhancer, rather than a risk reducer. This suggests that it would only be appropriate in portfolios with a high real rate of return target. Moreover, given the large spread between the annual returns earned by top quartile versus bottom quartile venture capital funds (Kaplan and Schoar estimate this gap at 20% over the 1980 - 2001 period), and absent an investable index product, potential venture capital investors face the problem of identifying a skilled fund manager. If you have no confidence you can do this, probability suggests you will be better off not investing in venture capital.

However, when it comes to investing in hedge funds, an investor's decision is made considerably harder by the growing number of index products that are available, not just on a broad index, but also on sub-styles like Equity Market Neutral and Global Macro. The argument in favor of investing in hedge funds index products runs like this. (1) I know I lack the skill to pick top quartile hedge fund managers. (2) However, I have the risk capacity to pursue higher returns than are available from my well-diversified, low-cost beta (asset class index fund) portfolio. (3) Managers of traditional “long-only” actively managed mutual funds are charging me relatively high prices for a mix of systematic (beta) and unsystematic (alpha) returns that are often times highly correlated with the returns on other parts of my portfolio. (4) By investing in an Equity Market Neutral hedge fund style index, I can obtain, at a relatively low cost, some (close to) pure alpha return that should have a low correlation with the rest of my portfolio. The same is true for a Global Macro hedge fund index product. (5) I accept the risk of a decline in forecasting skill (and therefore returns) as the hedge funds that underlie the index products in which I am investing grow in size, and the overall hedge fund market becomes more competitive.

In sum, for most of us, investing in hedge funds will never be a fast and easy path to riches. On the other hand, for those investors with sufficient risk capacity, investable hedge fund indexes provide a low cost alternative with a reasonable probability of adding some uncorrelated returns to their portfolios.

| This Month's Issue: Key Points | This Month's Letter to the Editor: T.Rowe Price and Oppenheimer International Bond Funds (Alternatives) and Schwab One Source for II's Model Portfolios | Global Asset Class Returns | Equity Market Valuation Update | Should You Be in Hedge Funds and Private Equity? | Product and Strategy Notes: New Commodity Index Product, Competition for DFA, New Rydex Hedge-Type Fund, Cost of Active Management, Latest S&P SPIVA's Report and New Bridgewater "All Weather Funds" in Australia |