Tuesday, July 28, 2015

Hedge Funds: Balancing Risk & Reward?

This recent article by Brett Arends points out hedge funds have not performed all that well this year.

The same goes for recent years. Arends writes those "who put 20% of their money in a federally insured bank savings account, and the other 80% in a random collection of stocks from around the world, picked by monkeys," outperformed in a meaningful way hedge funds in 2012, 2013, 2014, and so far in 2015.

Well, at least to me, that seems a rather too short time frame to judge relative performance.

In this article, Morgan Housel looked at a somewhat longer period of time. He points out, from 2002-2013, hedge funds underperformed a simple mix of 60% in stocks and 40% in bonds.*

The 60/40 mix had slightly higher returns along with slightly lower volatility.**

Some hedge funds argue that their goal isn't to match or beat the S&P 500, it's to balance potential rewards with downside risk and limit volatility or something similar. So, with this in mind, both Arends and Housel chose to compare hedge fund returns to a mix that similarly attempts to balance rewards with downside risk.

I'd add that some make the assumption that risk and reward need always be positively correlated.

Well, that's just not necessarily the case.

Now, consider that the typical fees of a hedge fund will be something like two percent of assets under management plus twenty percent of the profits generated (if any).

The two percent is generally paid by investors whether there's a profit or loss.

Arends points out that this means...

"Do the math. If the average investment portfolio earns 6% a year, your hedge fund manager has to earn 9.5% before fees before you even break even. In other words, the manager has to beat the market by about 60%. Per year. Good luck with that."

It may not be impossible to outperform by that much, but consider how many experts underperform over the longer run with, in general, a much lower frictional drag from fees. Also, consider how these fees impact the risk-reward for investors. In other words, the act of reducing fees would, in itself, take out some of the downside risk which is what the hedge funds often contend is a prime objective.

And the above hedge fund results just might be an optimistic take. It turns out that the "hedge-fund indexes flatter the industry's performance, because they are weighted heavily towards the funds that survive and report data."

So how has hedge fund performance affected investor behavior?

Is there any evidence investors are moving out of hedge funds?

Not at all.

From an article in the Wall Street Journal:

"Large corporate pension funds have quadrupled the share of their portfolios invested in hedge funds over the past five years..."

More generally, hedge fund assets under management is now, depending on the source, something like like $ 2.5 trillion or maybe even $ 3.0 trillion in assets. Big numbers. That compares to just $ 38 billion in 1990. So hedge funds have been gathering assets in a substantial way over the past two and a half decades (and in more recent years). At their current size, these funds will collect some serious fees from their investors, including those pension funds, with just mediocre performance.
(The management fees alone would be $ 50-60 billion even if no profits are generated.)

I'm not necessarily surprised by this sort of thing. Better to simply recognize why the behavior exists then do whatever can be done to avoid it.

This paper looks specifically at hedge fund investor performance from 1980-2008:

"...we find that the real alpha of hedge fund investors is close to zero. In absolute terms, dollar-weighted returns are reliably lower than the return on the Standard & Poor's (S&P) 500 index, and are only marginally higher than the risk-free rate as of the end of 2008.The combined impression from these results is that the return experience of hedge fund investors is much worse than previously thought."

This inevitably now has a big impact on institutional investors (pensions, foundations, educational institutions). Why? Apparently, at least 60% of the money invested in hedge funds these days comes from institutional investors.

Adam

Related posts:
Index Funds vs Actively Managed Funds
John Bogle on Investor Returns
Buffett's Hedge Fund Bet
John Bogle's "Relentless Rules of Humble Arithmetic", Part II
Index Fund Investing Revisited
Charlie Munger on Complexity, Hedge Funds, and Pension Funds
Why Do So Many Investors Underperform?
When Mutual Funds Outperform Their Investors
John Bogle's "Relentless Rules of Humble Arithmetic"
Investor Overconfidence Revisited
Newton's Fourth Law
Investor Overconfidence
Chasing "Rearview-Mirror Performance"
Index Fund Investing
Investors Are Often Their Own Worst Enemies, Part II
Investors Are Often Their Own Worst Enemies
The Illusion of Skill
Buffett's Bet Against Hedge Funds, Part II
Buffett's Bet Against Hedge Funds
The Illusion of Control
Buffett, Bogle, and the "Invisible Foot" Revisited
If Buffett Were Paid Like a Hedge Fund Manager - Part II
If Buffett Were Paid Like a Hedge Fund Manager
Buffett, Bogle, and the Invisible Foot
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
Bogle: History and the Classics
When Genius Failed...Again

* Vanguard Balanced Index Fund (60/40). The fund, like many from Vanguard, is rather low cost relative to peers.
** Volatility is not the definition of risk though some choose to treat it that way.
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