THE BEAR'S LAIR Hedge fund Gotterdammerung
By Martin Hutchinson
The past 30 years have been notable for the rise of hedge funds, organizations
that compete with the top Wall Street investment banks in remuneration, while
charging their investors fees far above those traditional for investment
management services.
Hedge funds had a mixed record in 2007-08; there were several large failures
but also some notable successes. However in 2010 and 2011 hedge fund
performance has been distinctly below par, and it is appropriate to wonder
whether their rationale for outsize fees and remuneration will continue to
prove convincing over the long term.
Hedge funds enjoyed a brief burst of success in the late 1960s, a period like
the last 16 years of considerable speculative froth
(albeit with significantly higher real interest rates - the annual average real
10-year treasury bond yield was 1.77% in 1967 and 0.94% in 1968, still low but
above the recent sub-zero levels). It was the era of "gunslinger" investment
managers like Jerry Tsai, whose Manhattan Fund pulled in a then record $247
million on its launch in 1965. Naturally, in such an environment, it was
appealing to wealthy investors to employ a specialist investment manager to
achieve even higher returns, using a "hedged" strategy going both long and
short.
In the event, the "hedged" strategy was not truly hedged, but got creamed in
the difficult markets of 1969-72. By the time I was attending Harvard’s
Investment Management class in early 1973 under the estimable Professor Jay
Light, hedge fund managers had become figures of professorial fun, "rolling the
dice" by investing continually in the mythical "XYZ Datawhack", promising
outrageously high returns to their investors and losing their shirts.
Professor Light contrasted them however not with traditional value-oriented
investment managers but with the then new Efficient Market Hypothesis (EMH),
which said that superior investment returns were impossible over the long run.
At one point, we were all asked what returns we expected to achieve on our
investments; the classmate who responded with "25% per annum" was duly mocked.
My own response of "15%" was equally contrary to the EMH in an era when stocks
had been shown to have a long-term return of 9% but Light, while a proponent of
the EMH, was not fanatical about it.
For a decade or more after 1973, it appeared that hedge funds would remain a
quaint relic of the 1960s, marginal to the overall market. After all, their
central claim to make superior returns was declared by the EMH to be bunkum, so
why would anyone invest in them?
The new trend was indexing (investing to match the performance of a
pre-determined share index); the new investment paradigms were Vanguard,
manager of the Vanguard 500 Fund, the largest index fund, and Fidelity, manager
of the Magellan Fund, actively managed by Peter Lynch with a sober style and an
excellent long term growth track record.
If you were a true believer in the EMH, you went with Vanguard, if you were a
skeptic, you went with Fidelity. Both funds offered and marketed low fee and
expense ratios, so your investments lost less than in other funds to investment
management costs. Either way, it appeared to make no sense to pay much higher
fees to a hedge fund, when you could get Peter Lynch to manage your money for
very little.
Hedge funds did not disappear, however. Instead they morphed into funds
investing in non-traditional areas, such as commodities and derivatives, with a
heavy trading orientation, using massive leverage and no longer hedging their
returns (except to the extent that a commodities or derivatives investment
might move independently of the traditional stock market). Naturally over time,
with many hedge funds invested across a wide spectrum, a few were very
successful. Since those successful funds had very high fees, including the
notorious 20% "carry", a 20% skim off the investment returns, taxed at only 15%
by a compliant congress, they rewarded their sponsors with outsize wealth.
Those sponsors in turn were able to market their track records to institutional
investors, pulling in amounts of money that would reward the sponsors with
outsize wealth even if the funds produced only average returns. Any time you
can figure a way to make 20% of the investment returns on say Harvard
University’s $35 billion endowment or the TIAA-CREF pension fund, you will make
yourself very rich. Hedge fund sponsors such as John Henry, who had got lucky
initially in agricultural commodities, were able to undertake such spectacular
feats of billionaireship as buying the Boston Red Sox within a mere two decades
of their startup.
By the EMH, the returns achieved by hedge fund managers were impossible - the
Hypothesis has no small print saying that while outsize returns are impossible
in the stock market, they are perfectly feasible in commodities, derivatives
and other non-traditional sectors.
In reality, hedge funds have had a very good run, based largely on the
availability of excessive leverage funded by over-expansionary monetary
policies since 1995 - and the "survivorship bias" is huge. Unsuccessful hedge
fund managers have little money or power, and both they and the industry in
general have every interest in suppressing knowledge of their failures rather
than publicizing it.
However, even institutional money pools, who professed total belief in the EMH,
were seduced by the successful hedge funds' track records and the allure of
"diversification" into dumping high percentages of their funds into these
hugely expensive vehicles. Expansive new theories were propounded - the "Yale
Model" in particular - and endowment managers were rewarded with about 100
times the remuneration of the Bursar of Trinity College, Cambridge, owner
during these years of a track record that was equally good if not better, based
on traditional long-term-oriented investment in stocks and real estate
development.
Hedge funds were able to expand because of one very simple truism: the
characteristics that go to making a good investment manager are almost
impossible to sell. My recent association with retail investment has emphasized
this: if you offer "a moderately superior investment advisory service that will
beat the market most of the time, and through care and diversification will
avoid heavy losses" you will find absolutely NO takers. Instead you have to
sell the service like a 19th century medicine man, picking individual examples
of spectacular performance and promising the unachievable, with details only
visible to those who read the small print VERY carefully.
Yet believers in the EMH will tell you even modest outperformance is
impossible, while even EMH non-believers like myself will assess it as about
the best anybody can do. Even Warren Buffett and Peter Lynch only beat the
market spectacularly for a decade or so, producing returns later in their
careers that did little better than the market, or as with Buffett during the
late 1990s tech craze, underperformed it.
Hedge funds, even if in reality they can offer no more than the modest claims
above, have two great advantages in marketing to both wealthy individuals (who,
unsurprisingly, can be played on with the same techniques applied to merely
affluent individuals) and institutional investors (themselves managed by
affluent individuals subject to the same sales techniques).
First, only hedge funds with successful track records will be doing the
marketing - the failures will crawl away into a corner - so the buyers will
have the impression that all hedge funds are successful, by some kind of magic
investment technique. Second, the SEC’s restriction of hedge fund sales to
"wealthy" individuals with a net investible capital of $5 million or more,
while relaxed recently, allows foolish investors, individual and institutional,
to think they are accessing a superior investment not available to the common
man. In retail investment sales, class warfare is a successful marketing tool
("the profits secret Wall Street won’t tell you"); in hedge fund marketing,
snobbery is equally effective.
However in the last year or two, hedge fund returns have started to look
decidedly ordinary. That’s not surprising with so much money having poured into
investment techniques that do not themselves have much magic involved.
According to HedgeFundNet, hedge funds returned only 10.87% in 2010, compared
to a return on the S&P 500 (available even to the plebs through the
Vanguard 500 Fund) of 30.84%. In the first six months of 2011, hedge funds have
made a return of only 0.42%, compared to an S&P 500 return of 6.02%.
Hedge funders will tell you that this is an unfair comparison; they are
"absolute return funds" and so cannot be expected to beat the index in rising
markets. However 0.42% over six months is a lousy absolute return, given the
risks involved - and don’t forget that one class of hedge funds, those involved
in commodities, should have done very well indeed over the period.
Since June, of course, the market has been weak, and we have started hearing
stories of such as the Paulson Advantage Plus Fund, down 38.7% on the year -
making it a Disadvantage Minus Fund for its unfortunate investors.
Yes, hedge funds beat the S&P 500 in 2008's lousy market, thus allegedly
justifying allocating funds to them for "diversification", but the reality is
they didn't beat it by all that much, and having underperformed in 2009-10,
when the market was strong, they have mostly spent the 2007-11 period losing
their investors money - and those few that were successful siphoned off
gigantic amounts to their managers.
Hedge funds, I would remind you, rely on leverage. It's thus not surprising
that they have sprouted like weeds in the prolonged easy-money period since
former Federal Reserve chairman Alan Greenspan's monumental policy error of
February 1995. In the years to come, the piper will have to be paid through
higher interest rates, to rebuild America's depleted savings base and to wring
inflation out of the system.
This will be very beneficial for the economy, and will re-employ millions of
unfortunate ordinary workers who must be thinking they will never work again.
It will however result in a mass cull of hedge funds, as wealthy individuals
and institutions come to their senses and realize that by incurring exorbitant
costs on the management of their money they are assured only of the exorbitant
costs, and not of superior investment returns.
Hedge funders who haven't yet banked enough billions (or whose fortunes are
drained by the inevitable future lawsuits) will have to find a way of making a
genuinely honest living. Poor them!
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found on the website www.greatconservatives.com -
and co-author with Professor Kevin Dowd of Alchemists of Loss (Wiley,
2010). Both are now available on Amazon.com, Great Conservatives only in
a Kindle edition, Alchemists of Loss in both Kindle and print editions.
(Republished with permission from PrudentBear.com.
Copyright 2005-11 David W Tice & Associates.)
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