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Pragmatic Capitalism

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Why Hedge Funds Are Sucking Wind

The basic arithmetic of the financial markets is very simple. At the aggregate level there is just one portfolio of all outstanding financial assets. These financial assets generate “the market” return. This means that the holders of these financial assets must, by definition, generate the post-tax and post-fee return. That is, the aggregate of investors will generate the top line return from all outstanding financial assets MINUS any taxes and fees paid. This means that, in the aggregate, no one “beats the market”.

One industry that has started to feel the pressure of this arithmetic is the hedge fund industry.  Hedge funds as a whole have lagged a basic 60/40 stock/bond portfolio for the last decade. And this doesn’t even account for the numerous well known reporting errors in some hedge fund databases (see here and here).  This poor performance wasn’t always such a glaring problem.  An older study from the Journal of Financial Economics found that performance has started to lag as the industry has grown.  While hedge funds generated good performance between 1980 and 1992 they began to lag substantially in the 90’s and 00’s.  Despite this, the assets in hedge funds have continued to grow.  So, what’s going on?

The arithmetic of high costs is applying itself as aggregate hedge fund data becomes more representative.  In other words, as hedge funds grow in quantity and assets we’re getting data that better reflects the aggregate performance of these managers.  And as the industry grows we’re nearing a world where alpha becomes a mirage since everyone can’t charge 2&20 on the global aggregate portfolio and expect to “beat the market”.  In fact, as hedge funds grow in assets they’re simply chewing into that aggregate return with their high cost structure.  And as Ibbotson, Chen, Zhu noted, it’s the costs in hedge funds that most eat into the excess returns.

Think of it this way – over the last 40 years, a 50/50 stock/bond portfolio (a rough approximation of the average historical aggregate financial market portfolio) has generated a 9.5% annualized return.  If hedge funds managed all of these assets for the rest of us then we’d earn about 7.5% per year and the hedge fund managers would pocket their 2% management fee for generating the market return.  When you’re taking 21% of the aggregate performance in fees then you’re creating quite the uphill battle for yourself in terms of justifying your value add.  And charging 21% for what is essentially a type of equity insurance (your “hedging”) is simply too expensive when the market is creating far less expensive forms of equity insurance (like a 60/40 that costs less than 0.25% per year).

Of course, I don’t mean to demean “active” asset management. Anyone who understands the arithmetic of asset allocation should also know that there’s really no such thing as “passive investing” and that the arithmetic of the aggregates means the vast majority of investors will consistently underperform.¹  The poor performance of “active” managers like mutual funds or hedge funds doesn’t prove anything other than the obvious fact that high fees chew into aggregate returns.  And since we all inevitably deviate from global cap weighting we all end up being “active” even if only marginally.²  Further, the aggregate index performance that so many people chase is a mere illusion. “Alpha” is the proverbial carrot and stick being dangled in front of our faces usually sold to us in exchange for justifying a very high fee structure.

The kicker is that there are very inexpensive ways to be active and there are very expensive ways to be active.  Many hedging strategies like a low cost index based 60/40 stock/bond allocation beat hedge funds primarily because they’re a very tax efficient and low cost form of active asset allocation.³  Hedge funds lose because they’re an expensive form of hedging.  And they’ll continue to lag over long time frames until their cost structure drops substantially.  None of this means hedge funds are necessarily bad or that they can’t add value.  An efficient portfolio manager and a good advisor has been shown to create upwards of 3% in added value relative to what most investors do (which is highly inefficient). Tax and fee efficient hedging strategies will always be appropriate for most savers. The problem with most hedge funds is that the indexing community is lightyears ahead of them in creating low cost hedging strategies and at some point the tide will turn sharply against the high fee managers who sell the pursuit of alpha wrapped in promises they arithmetically cannot deliver.

Sources:

¹ – The Myth of “Passive Investing”, Moi

² – What is an Index, by Andrew Lo covers this topic in depth and highlights how nebulous the concept of an “index” can be.  After all, something like the S&P 500 is nothing more than an actively selected group of 500 large cap domestic US stocks.  It doesn’t represent all financial assets, all stocks or even all US stocks.  It is an actively chosen slice of a certain asset class inside of one domestic market.  This index is as arbitrarily selected as the thousands of other indices we see cited regularly.  

³ – Some people use the term “indexing” to imply passive investing, but this is largely untrue.  Of the $3.4T in assets current in Index Funds about half of that is in ETFs.  These ETFs have an average annual turnover of 864%!  How’s that for “passive”?

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