Advisers’ next chore might be to clip the hedges

To hedge or not to hedge?

That was the question in Chicago last week at the InvestmentNews Alternative Investments Conference.

Facing off were two noted investors.

Arguing the case against hedge funds was Simon Lack, principal and founder of SL Advisors LLC.

Defending hedge funds and alternative investments was Ed Butow-sky, managing partner of Chapwood Capital Investment Management LLC.

Size affects hedge fund returns negatively, Mr. Lack said.

“Better returns are associated with a smaller industry,” he said.

The internal rate of return for hedge funds since 1998 has been half as good as the return of Treasury bills, Mr. Lack said.

“In the 1990s, hedge funds did really well, but as investors have come into hedge funds, returns have come down,” he said.

“Smaller is better for hedge funds,” Mr. Lack said, noting that the hedge fund industry controls $2 trillion in client assets.

“Today, the hedge fund industry is overcapitalized. There are some good hedge funds, but the aggregate return has been poor,” Mr. Lack said.

“This has been a fairly major flawed analysis by the institutional investing industry,” he said.

The standard hedge fund fee structure, in which the manager charges 2% of assets and also captures 20% of the return, continues to be controversial.

“Everyone knows that is egregious,” said Mr. Lack, who recently wrote a book on hedge funds.

“Today’s hedge fund investors may think 7% [annual] return is a reasonable expectation, but that means every year would be a record year for the industry,” he said, adding that clients should have a very small allocation — 1% to 2% — to hedge funds in their portfolios.

“I’d have a lot more than that,” Mr. Butowsky countered. He recommends a hedge fund allocation in client portfolios of 25%.

Mr. Butowsky said that Mr. Lack’s “information doesn’t support reality.

“We’re talking about performance but really need to ask: What is the purpose or benefits of having hedge funds in the portfolio?”

“The reason we include hedge funds in the portfolio is to reduce the risk in clients’ portfolios,” Mr. Butowsky said.

“There are 14,000 hedge funds in the U.S., but only 250 are institutional-quality hedge funds,” he said. “Our goal is to make portfolios efficient and get rid of waste.”

Mr. Butowsky said that his hedge fund portfolio performed “miserably” last year, but he isn’t going to dump the investments.

“We have to be talking about the benefits of including this in the portfolio, not as a stand-alone,” he said. “As advisers, our goal is to help manage risk, and we have to add alternatives to the portfolio.”

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