Apparently, hedge funds aren't doing so well this year. From this CNBC article on hedge fund performance:
They are supposed to be the smart money—the best of the best....
The article later adds...
Hedge funds as a group are badly underperforming this year, which could lead to a series of redemptions, closings and rethinking of the lofty fee structures the managers of these alternative vehicles enjoy.
Many know the magic of compound returns, but fewer seem to fully appreciate what John Bogle calls "the tyranny of compounding costs". In the aggregate fees, commissions, and other "frictional" costs can only subtract, too often substantially over the long haul, from total returns. There's no way around it.
Little or, well, nothing of real use is created and the costs aren't exactly immaterial.
An individual investor or professional manager may be outperform but the industry as a whole, after frictional costs are subtracted, can't be anything but a net drag on returns. Productive assets will produce a certain amount of value over time with or without some money manager acting as the middle man. So the fees charged by professional investment management simply subtract (and certainly cannot add). I know some may challenge this premise but, at a minimum, lots of talent wakes up every day engaged in activities that seem mostly non-productive or of little utility.
There are those that rationalize the benefits of all these frictional costs (improved capital allocation being one of them) but I'm mostly skeptical of the arguments that I've heard.
(My mind remains open to the possibility that there are other benefits I do not fully appreciate.)
I do think that investment professionals who stay with their investments for a long time and try to engage constructively in corporate governance issues can add some real value.
Higher quality management, better business strategies, improved capital and resource allocation among things can be the result.
Otherwise, these costs meaningfully subtracts from the long-term returns for investors overall. The fees paid may benefit an individual investor who happens to be investing with someone, through luck or skill (or maybe a little of both), produces above average results. So, for that individual investor, it works at a micro-level. The best professionals can outperform by enough on a consistent basis to even justify their fees. I'm not arguing otherwise. This doesn't alter the arithmetic reality that all the salaries, fees, bonuses paid to money managers subtracts from returns of investors as a whole.
"If we [the investment industry] raise our fees from 0.5 percent to 1 percent, we actually raid the balance sheet. We take 0.5 per cent from what would have been savings and investment and turn it into income and GDP. In other words, you're taking money that would have become capital and chewing it up as bankers' bonuses." - Jeremy Grantham
Jeremy Grantham: 'We Add Nothing But Costs'
So it's the conversion of capital to income. Think of the compensation that's paid to investment management professionals (sometimes what seems an endless parade of these professional managers appear on business news each day). Some (maybe even many) are very capable and work very hard for their clients no doubt, but there's no getting around that their rather substantial compensation is literally savings and investment being converted to income.
It's simple arithmetic. Allow the "tyranny of compounding costs" to play out for many years and we're talking some real money when it is all said and done.
These flaws are costly even if all the costs aren't necessarily measurable. To improve the system overall, reducing frictional costs and increasing the average holding period ought to be among the top priorities. Of course, if and when that might happen isn't knowable. So, until then, the individual investor can still choose to not participate in the folly (even if society still bears the costs, unfortunately).
More in a follow up post.
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