We like it when facts confirm our opinions. Probably a better way to phrase that is, we like it when our fact-based insights are ultimately recognized as true by a broader universe of more mainstream opinion.
You don’t get much more mainstream than The Economist, the venerable British newsmagazine. One of the leads in their December 20 edition was an article on hedge funds, a particular bete noire of ours for many years, titled Going Nowhere Fast.
As of the article’s publication date, the trailing one-year return of the HFRX index of hedge funds was +3%, compared to an +18% return for the S&P 500. Even worse, hedge funds under-performed the S&P 500 for nine of the last ten years, and under-performed a standard 60%/40% balanced portfolio by a cumulative 73% over ten years. (Balanced portfolio: 90%, hedge funds: 17%.)
Which begs the question: Why in the world does any sensible investor put his money in a high-cost, low-return investment with impossible-to-quantify risk?
Our position remains the same — the hedge fund emperor has no clothes. Hedge fund managers are paid ridiculously well for doing a bad job for most investors most of the time, while periodically putting the world’s financial markets at risk as an unintended by-product.
There is nothing in the performance of the asset class as a whole that justifies the standard fees of 2% of capital and 20% of profits. Quite the contrary, as documented above and in The Economist. I think Jean-Marie Eveillard, former First Eagle and SoGen mutual fund manager, said it best: “Hedge funds are a compensation structure, not an investment strategy.”
Remember my post of a few weeks back, about Steven Cohen of hedge fund SAC Capital? His own money represents $8 billion out of $14 billion in his fund. In no non-financial business of similar size, anywhere in the world, do the managers, rather than the investors, reap such an utterly disproportionate share of the total rewards of the enterprise.
In my mind, the strong performance of a small number of hedge funds does not justify including this asset class in a prudent portfolio strategy. This is even more true given the gruesome history of some of the top-performing hedge funds of the last two decades. Among high-flying funds that suddenly lost most or all of their value are Long-Term Capital Management (lost $4 billion in weeks in 1998, 95% of prior capital, and almost tanked the financial system), John Paulson’s Advantage Plus Fund (lost 51% in 2011 and 19% in 2012), and the two Bear Stearns High-Grade Structured Credit funds (lost 98% and 100% respectively in the 2008 financial crisis).
Over time, the primary marketing hook for hedge funds has changed from superior performance (not much of that visible) to diversification benefits. If diversification is the goal, do investors really need to pay such punitive fees to acquire it? After all, investors in equities are moving steadily away from actively-managed funds and toward index offerings.
What is the alternative to hedge funds? From time to time, we have considered engaging that question directly, through an alternative design based on the underlying architecture of our proprietary DYCOPS asset allocation process. For now, though, we’re content to just trash the competition.