Hi Guys,
The current weekend edition of the WSJ has an insightful article titled “Is It Time to Buy a Hedge Fund?”
The writers open the article by asking the question “Are they saviors or duds”?
As always the answer is that it depends. It depends on many variables and the goals, timeframe, aspirations, risk profile, market knowledge, and wealth of the individual investor. Another factor for consideration should be the investor’s perception of the market action and returns in the upcoming intermediate term.
Here is the Link to the article:
http://online.wsj.com/article/SB10000872396390444082904577605240804189020.html?mod=WSJ_PersonalFinance_PF14Enjoy.
Here are a few of my takeaways from the reporting, not in any particular order:
1. Recent Hedge Fund returns (since 2008) have been dismal relative to a conventional S&P 500 holding. For the decade that preceded 2008, the Hedge funds delivered superior outcomes. Could this be correlated to the more positive rewards of the most recent market period in contrast to a more uncertain, unsettled marketplace in the preceding decade? Alternately, could the dampened returns be attributed to a more competitive Hedge fund world in which 10,000 Hedge funds are basically competing with each other for a limited number of inefficient market opportunities?
2. The current estimated Hedge fund count of about 10,000 entries seems like a population explosion that is not sustainable. It is not difficult to picture many failures so survival is a risk issue. The author’s projected that the number of attractive funds only number in the 10s. Those are not attractive odds if an individual investor is making a management decision.
3. Hedge fund buyers are the same as Mutual fund buyers; we chase hot fund performance. The data cited in the WSJ article suggests that Hedge fund holders secure slightly less than one-half the returns of the funds themselves. In a minor way, this outcome is a little superior to the typical mutual fund owner who, on average, only realizes about one-third of his mutual fund’s annual rewards. Shame on all of us.
4. Hedge fund costs are exorbitant, and as everyone knows, costs matter greatly and directly reduce our market participation results. The journalists propose alternative, replicator mutual funds as a cost containment option. As a general observation, Morningstar data demonstrates that it is no easy chore to select a winner in this category either. The growth in the Alternate fund category is exceptional; performance has been less than exceptional. It has been mixed at best, and some would say disappointing.
5. Fund management is a risk component when operating in the actively-managed mutual fund arena. It is an even more risky element when deciding on Hedge fund management because of looser reporting regulations, because of limited access to exit the fund, and because of survivorship issues. Life is not simple for even the very wealthy investor who can qualify for stringent Hedge fund participation. I would venture a guess that there are a higher percentage of quack theories and hair-brained managers in the Hedge fund industry than in the conventional mutual fund arena. Since many Hedge funds sell excess returns, aggressive risk-taking is almost mandatory. Of course, some Hedge funds design their portfolio to dampen risk; and dampened risks often translate into muted returns. There are no free lunches anywhere.
Enjoy the article. Your observations and comments are always welcomed.
Best Regards.
Comments
There are tremendous mutual fund managers (although pretty few I'd say) and tremendously skilled hedge fund managers (who I think number more than similarly highly regarded mutual fund managers, although on an overall % basis, the number is also likely less/much less than it should be.)
Hedge fund managers have far more tools to work with (want to invest in commodities? funds such as the Whitebox fund profiled in Barrons went and bought grain elevators a couple of years ago - people can be dismissive of that kind of alternative investing, but if you can have a skilled manager and that level of freedom to go beyond the traditional, that can be a tremendous positive. There are funds that can invest in farmland, or specific real estate instead of REITs, etc etc etc.)
Still, it's a matter of how those tools are used - under the right leadership, there have been remarkably successful hedge fund managers doing all manner of varied strategies. Hedge funds are more expensive because they have a wider array of tools at their disposal (and freedom in general) and have the ability to trade FAR more rapidly and capitalize FAR more quickly on opportunities than a mutual fund can.
As for hedge funds underperforming, the amount of hedge funds replicating strategies can be an issue, which has been discussed with quant funds - or, something far more simple - it's happened before. "Investors have seen this disappointing performance before. From 1992 through 2011, hedge funds underperformed the annual returns of the S&P 500 nine times. In 1997, for instance, they gained 23%, 10 percentage points less than the S&P 500's 33% return. In 1998, hedge funds returned just 7.9%, about 21 percentage points less than the benchmark index's 29%.
Those who stuck around were rewarded for it. Hedge funds returned 38% from 2000 through 2002, while the S&P 500 suffered losses of 38%.
The reasons to own hedge funds are getting more compelling, many advisers say. The possibility of a euro-zone implosion and economic uncertainty in the U.S. could leave the funds well-positioned to cushion the fall—and even profit—if markets suddenly swoon. And if systemic risks diminish, hedge-fund managers could once again flourish."
Another reason why hedge funds may have underperformed recently is because they may have been being silly and taking things like fundamentals into account rather than just going along with the desired effect of trying to push asset markets higher with incredibly loose monetary policy. This apparently is now called "Hussmaning".
"For the decade that preceded 2008, the Hedge funds delivered superior outcomes. Could this be correlated to the more positive rewards of the most recent market period in contrast to a more uncertain, unsettled marketplace in the preceding decade?"
The market is more certain and settled now than the years prior? Take out more enormous central bank assistance, rumors, BS and intervention THAN EVER BEFORE and I'd love to see what the market does without those enormous (and continued!) training wheels. If everything is so wonderfully certain and settled, we wouldn't be having discussion of the need for a third round of QE. The view of the market seems largely focused on WWBD? (What Will Bernanke Do?)
Additionally, there have been periods of hedge fund underperformance in the past - the hedge fund underperformance in this period could be in part due to crowding in some strategies (such as quant strategies - there was a great Reuters article about this that I can't find right now - where some funds have literally gone back to price trends thousands of years ago in order to try and capture some data advantage), but I think at least a fair amount of it is due to some similarities to why Hussman has underperformed.
Chasing returns is nothing new - look at Paulson and the miserable time he's had after the subprime mortgage trade, and one wonders how much that success was due to former co-captain Paolo Pellegrini.
"The author’s projected that the number of attractive funds only number in the 10s."
Uh, how many truly attractive mutual funds are there out of the universe of mutual funds? It's not nearly as high a % as it should be, either, but I think the hedge fund world possesses a larger amount of highly regarded managers. You've also seen a number of highly skilled mutual fund managers lately - such as Rao of Marsico Flexible, Iben of Tradewinds and Decker of Janus jump ship to hedge funds (and there's been a few others lately I'm forgetting.)
Replication mutual funds have largely underperformed, I think, because many of these funds are effectively hampered by the restrictions of the mutual fund structure. They were an attempt to offer "hedge funds to the masses", but I think they aren't capable of fully pulling off some of the strategies, such as the managed futures funds.
I don't believe there's one managed futures mutual fund that has been truly successful, and while one can say the managed futures strategy can have off periods, many of the large managed futures hedge funds in recent years have had significantly better performance than any of the managed futures mutual funds. I just don't believe a mutual fund can be nimble enough to pull off the strategy, and it's not the strategy that's the issue - there are many immensely successful managed futures hedge funds. It's not that there aren't skilled managers at the helm of some of the managed futures mutual funds, either.
The mutual fund that I think is probably closest to a hedge fund is Marketfield (MFLDX), and that fund continues to do quite well.
Hi Scott,
Thanks for your thoughtful and thought provoking reply. It expanded both the thinking and opinion horizons on the topic. Great stuff.
We both see the gathering Hedge fund dynasties in much the same light. I agree Hedge fund managers are very likely smarter than Mutual fund managers. Hedge funds draw their cadre from the superior performing mutual fund management pool. However, successful financial wizards often fall victim to excessive ego trips caused by an overestimation of skill sets and an underestimation of the luck contribution to their performance story.
There is little doubt that Hedge funds have prospered recently as their numbers and their increasing wealth accumulation have been nothing short of phenomenal. However, it is not clear if that wealth accumulation has filtered down to the private investor level.
The financial sector is populated by plenty of smart folks. But smart people do not always produce superior outcomes. Many books have been produced that fully document that observation.
Simon Lack has generated a scathing book of hedge fund failures in his “The Hedge Fund Mirage”. He observes, with a distortion of Sir Winston Churchill’s famous World War II remark, that “Never in the field of human finance was so much charged by so many for so little”.
The books opening, eye-popping statistic reveals that if all the money ever invested in hedge funds had instead been safely placed in US Treasury Bills, the returns would have been double those delivered by the inventive and the undisciplined Hedge fund army. The industry does have a few outstanding exemplars; their impact is severely diluted by the more numerous miscreants and copycats.
I’m thinking now of the likes of John Merriwether’s LTCM over-leveraged demise, of Amaranth Advisors highly publized 2006 failure, and of course, of Bernie Madoff’s malfeasance and disgrace.
A few papers on the Hedge fund industry highlight this aspect from several perspectives, both supportive and otherwise. On an anecdotal basis, the Hedge fund record, at least that fraction of it that the average investor has access to, is littered with startling survival dropouts and shocking return disparities.
Immediately following are two distinguished references that take opposite sides of the Hedge fund risk-reward controversy. The first is coauthored by Burton Malkiel of “Random Walk Down Wall Street” fame; the second is by a less well known authority, George Van from Van HF Advisors International who wrote that the Malkiel-Saha paper was deeply flawed.
A Link to a summary the Malkiel-Saha paper by the authors themselves follows:
http://www.frbatlanta.org/news/conferen/06fmc/06fmc_malkiel.pdf
The Link to Van’s paper is:
http://www.intelligenthedgefundinvesting.com/pubs/rb-gvzs.pdf
Note that both references were generated by vested interests and are likely to have views that are shaped by a divergent set of financial incentives. A basic understanding of the motivations underpinning any source is critical when assessing the merits and shortcomings of the position advocated.
A more balanced, and perhaps less biased study was reported by Morningstar. The work was headed by Roger Ibbotson and is titled “The ABCs of Hedge Funds”. It includes data through 2009. Here is the Link to the paper:
http://corporate.morningstar.com/ib/documents/MethodologyDocuments/IBBAssociates/ABCHedgeFundReturns.pdf
The paper shows that “results indicate that both survivorship and backfill biases are potentially serious problems. Adjusting for these biases brings the net return from 14.88% to 7.70% for the equally weighted sample.”
This is yet another buyer beware cautionary signal. You get to choose your own poison. The debate and the controversy, even about the data sources, rage with spirited interchanges.
George Soros surely demonstrated the Midas Touch with his currency genius, gambles, and attacks. In 1992, Soros's Quantum Fund became famous for "breaking" the Bank of England, forcing it to devalue the pound. The Quantum fund is no longer available to outsiders, but had a sterling record under the leadership of Soros, Jim Rodgers, and Stanley Druckenmiller. It’s funny to recollect that I once tried to become a client, but didn’t satisfy their high net worth standards.
Consider Julian Robertson, his Tiger fund, and his long-short investment strategy. It worked until it stopped working. He closed his Tiger fund in 2000, but is still an active player by providing seed money to promising Hedge fund manager candidates. He is a brilliant investor as are Myron Scholes and Robert Merton, Noble Laureates, whose analytical models contributed to the LTCM problem.
The risks for a small investor is the potential for massive losses. The potential upside is extremely limited when considering the long term persistency requirements of most investors, and the eroding effects caused by high annual fees,
The huge disparity of Hedge fund historical performance among its numerous categories is still another cause for caution.
Hedge funds have a checkered record, even under the watchful scrutiny of institutional agencies like Harvard, Princeton, and Yale. The managers of these endowments split their resources between conservative Index holdings and far more aggressive Hedge fund operators. If these super-investors can not make a definitive decision, it is a daunting challenge for even a knowledgeable private investor. If selecting an active mutual fund manager is like walking through a briar-patch, deciding on a Hedge fund manager must be like choosing a pathway through a minefield.
The diverse categories that populate the Hedge fund industry add to the confusion and uncertainty. Performance differences between these categories are huge and unstable over even intermediate timeframes. The rewards are there, but so is the risk, especially for an individual investor who is typically denied access to the truly superior Hedge fund managers. These guys are few, and their best interests are served by seeking institutional clients. You know who they primarily serve.
From my perspective, the Hedge fund waters are too murky for the individual investor. The reporting is spotty and the regulations are too thin. Navigating these less well charted choppy waters is too demanding a sailing chore given the uncertain risk-reward tradeoffs.
Thanks again for your fine submittal.
Best Wishes.
Thank you very much for the most detailed report and the links. I found the link to Ibbotson most interesting. Some of their conclusions are in fact quite positive. The abstract of their paper says:
"Over the entire period, this return is slightly lower than the S&P 500 return of 8.04%, but includes a statistically significant positive alpha. We estimate a pre-fee return of 11.13%, which we split into a fee (3.43%), an alpha (3.00%), and a beta return (4.70%). The positive alpha is quite remarkable, since the mutual fund industry in aggregate does not produce alpha net of fees."
Their conclusions about alpha are most interesting. In the text, they say that the large hedge funds are doing even better.