By Robert Klemkosky

Korea has approved the formation of hedge funds with expectations of becoming a global player and having a good alternative investment for investors. One piece of advice to investors: Be careful what you wish for. All of the evidence shows that the rewards of hedge funds accrue more to the hedge fund managers than the investors.

The hedge fund industry has grown dramatically to become a $2 trillion institution from just $200 billion 12 years ago. There are more than 10,000 hedge funds worldwide, with the vast majority based in the United States and United Kingdom. Why such dramatic growth? The barriers to entry are low and the rewards, if successful, are enormous. Hedge fund managers are some of the most highly compensated in the world. They attract a lot of talent.

What are hedge funds? They are private partnerships where the manager has a significant personal stake in the fund. They are generally organized as limited partnerships or limited liability companies, many times domiciled offshore for tax reasons.

They are not regulated and are free to invest in a number of strategies using leverage and derivatives. Their investment strategy can be very narrow and concentrated or very broad, including stocks, bonds, currencies, derivatives and just about any other type of financial asset.

Investors usually pay an annual management fee of 2 percent and a performance fee of 20 percent of any gains achieved by the portfolio. If the fund should experience a negative return, that sets a high water mark which has to be exceeded in order for the manager to receive another performance fee.

Hedge fund investors usually have a lockup period of several years, in which investors are not allowed to withdraw money from the fund, so investments can be illiquid.

Originally, hedge funds were set up to hedge against market risk. Fund returns can be attributed to those that are correlated with the market, called relative or beta returns, and the returns that exist after eliminating market effects, called absolute or alpha returns.

The early hedge fund managers would buy perceived undervalued assets and short an equal amount of perceived overvalued assets thus creating a market neutral portfolio not affected by market conditions. Thus they offered an absolute alpha return that could be earned in good market times or bad.

Since the first hedge fund was formed in 1949, hedge funds have adopted a multitude of strategies. Very few are market neutral any more as experienced by many investors in 2008, but many still take long and short, but unequal, positions in stocks.

Others try to achieve absolute alpha returns through arbitrage strategies: convertible bond, mergers and acquisitions, capital structure, statistical and risk to name a few. Other hedge funds use corporate events or macro strategies to achieve alpha. The point is that hedge funds can invest, long or short, in any financial asset anywhere in the world, usually involving leverage.

How do hedge fund investors fare? There is not complete transparency as hedge funds have not been required to report returns. If a manager has good alpha and beta returns, he or she has a strong incentive to report returns to a database.

This would help them gather more assets and grow in size. If returns are mediocre or negative, they have no incentive to report returns and usually don’t.

Numerous other funds go out of existence over a time period; for example, more than 3,500 hedge funds have terminated operations worldwide since 2007, only to be replaced by new ones. But the industry is dominated by 100 or so hedge funds and the thousands of others don’t amount to much in terms of impact or creating wealth for investors.

The general perception is that hedge funds achieve an absolute alpha return of 3-5 percent annually. A recent study analyzed 10,000 hedge fund returns from 2004 to 2009, including database funds, non-database funds and terminated funds.

The funds had an average annual return of 1.13 percent with database funds providing a higher return than non-database funds as expected. Dead funds had a negative annual return over the six-year period.

A recent book by Simon Lack reports that hedge fund investors, after fees, earned only 2.1 percent annually since 1998, less than what they could have earned investing in Treasury bills or bonds plus having a lot more risk as experienced by most hedge funds in 2008. It appears that fund performance was better in the earlier part of the period when the hedge fund industry was smaller, $200 billion in 2000 versus $2 trillion today.

Lack estimates that hedge funds made gains of $449 billion before performance fees from 1998-2010 and $70 billion after fees. So $379 billion or 84 percent of gains were paid out to mangers leaving only $70 billion for investors. It is also estimated that since hedge funds came into existence that they have not provided positive alpha returns to investors. Investors have not yet recouped their hedge fund losses of 2008 which probably wiped out all previous gains. Plus hedge funds and their investors are subject to something called a “winner’s curse.”

As a hedge fund reports a series of positive returns, it gathers assets and grows rapidly. As a much larger fund, it suffers a big loss and wipes out all previous gains and then some. This was the recent experience of John Paulson, whose fund, Paulson and Company, had positive returns in 2008, 2009 and 2010, but suffered big losses in 2011 to the detriment of investors. The fund had increased five times in size over this period.

There is no question that some hedge fund managers have created vast wealth for their clients George Soros, Julian Robertson, Stanley Druckenmiller, Carl Icahn, Ray Dalio, James Simmons and Stephen Cohen just to name a few. When successful, hedge fund managers make a lot of money; the top 25 managers made $14.4 billion in 2011, an average of $576 million each. This includes not only performance fees but also their share of the gains in the portfolio. Ray Dalio of Bridgewater Associates made $3.8 billion in 2011. In 2010, the top 25 hedge fund managers made $22 billion or an average of $880 million each, so 2011 was a down year for them. John Paulson made $4.9 billion in 2010 only to lose investors 30-50 percent in 2011.

While hedge funds have been embraced as an alternative investment to bonds and stocks, the vast majority of managers have not created wealth for investors. That leaves open the question: Who benefits from having hedge funds?

So investors beware; the odds of you picking the next hugely successful hedge fund manager are not in your favor. Even if a hedge fund manager achieves several years of good returns, that does not guarantee long-term success; remember long-term capital.

The odds of Korea becoming a dominant player in this industry are not good. Korean hedge funds are late to the game, two decades late. They are more heavily regulated than in other countries and don’t have global arbitrage experience.

It will be difficult to catch up unless absolute returns are outstanding. It will take at least five years to establish a performance record and hopefully, Korean investors will fare better than elsewhere in the world.