Cliff Asness has a wonderful new piece on Bloomberg View discussing hedge funds. He basically argues that:
- Hedge fund criticism has been unfair largely due to false benchmarking.
- Hedge funds should hedge more.
- Hedge funds should charge lower fees.
These are fair and balanced statements. And they’re worth exploring a bit more.
The first point is dead on. The media loves to compare everything to the S&P 500 which is ridiculous. The S&P 500 is a domestic slice of 500 companies in a global sea of millions of companies. It neither represents “the stock market”, the “global stock market” nor anything remotely close to “the financial markets”. I have pleaded with people at times to stop comparing everything to the S&P 500. But no one listens to me so it’s not surprising that this continues.¹
Hedge funds are treated particularly unfairly here because, as Cliff notes, they’re not even net long stocks on average. The average hedge fund is only about 40% net long stocks. The portfolio is also comprised of bonds and alternatives making classification difficult to average out. But the point is that the S&P 500 is absolutely not a good comparison.² I would argue that the proper benchmark for all active managers is the Global Financial Asset Portfolio which is the true benchmark for anyone who actively deviates from global cap weighting (which is everyone by the way).
The second point is also clearly true as hedge funds have become increasingly correlated to the S&P 500 over time. Differentiation is what makes alternative asset classes valuable. Unfortunately, you don’t get much differentiation in hedge funds and I don’t think this can reasonably change as the industry grows because, as assets under management grow, the managers will inevitably start to look similar since there are only so many assets that can be held at the same time. The paradox of active management is that the more active everyone becomes the more all this activity starts to look like the same thing (minus taxes and fees).
The last one is my major point of contention. A globally allocated 40/60 stock/bond portfolio earned about 7.5% per year over the last 40 years. And this was in an era when that 60% bond piece averaged about 6.3% per year. Those days are long gone. I think it’s safe to assume that balanced portfolios will generate lower returns simply due to the fact that the bonds cannot generate the same returns in a 0% interest rate environment. Either that or the stock piece will probably expose the portfolio to more risk resulting in similar but riskier returns on average. I’ve discussed this in some detail and we even have some historical precedent for this when bonds generated about 2.5% returns from 1940-1980 during a period of low and rising rates.
So, the question becomes – in a world of low returns how can hedge funds justify charging something like 2 & 20 which cuts the total return by almost 50% assuming benchmark returns. Hedge funds have a huge hurdle to overcome on the fee side and the arithmetic of the markets shows us that they can’t all do it. That arithmetic is clearly coming into play in an environment where aggregate returns have been fairly weak. At the same time, many people clearly benefit from having an investment manager. Vanguard has shown that a good advisor/manager can be worth as much as 3% per year (which I suspect is high) and the average investor has been shown to do far worse than they do when someone like an advisor consistently slaps their hand away from making persistent changes. The value add of a manager is largely subjective and always personal, but I have a hard time believing that people should pay more for an asset manager than they do for doctors, accountants, lawyers, etc. In my mind, portfolio managers and advisors are more like personal trainers – they’re a luxury for people who know they’re not knowledgeable or disciplined enough to build and maintain a proper plan. But personal trainers shouldn’t cost you an arm and a leg.
I like Cliff’s points and there’s some good takeaways in there. But I still think point three is really difficult to overcome. Hedge funds simply charge too much. In a world where you can now mimic a hedge fund index for the cost of 0.75% it’s very hard to imagine that there’s any rationale for fees being higher than that on average. And I suspect that, like most high fee active managers, these sorts of funds won’t benefit investors in the long-run anyhow.³
¹ – This is not an entirely true statement. My wife listens to me on rare occasion, but has good reason to ignore most of what I say since it mostly involves rants about things like quantitative easing and other things almost no one cares about. My dog listens to me roughly 90% of the time though she selectively ignores me such as late last night when she got sprayed in the face by a skunk because she did not properly respond to my commands. My chickens do not listen to me at all. I am not sure if it’s because they are geniuses or idiots. Probably geniuses as they’ve clearly evolved to be unable to hear the Cullen Roche voice. By the way, if you’re still reading this you should probably be questioning your own evolutionary development.
² – Part of what’s exacerbated this problem is that Warren Buffett made a public bet with some hedge fund managers who decided it was smart to benchmark their performance to the S&P 500 on a nominal basis. I can only assume that Buffett drugged them before getting them to agree to this deal since only someone on drugs would benchmark hedge funds to the nominal return of the S&P 500.
³ – Yes, I know this is not a perfect hedge fund replicator, but it’s close enough.