Hedge funds: Useful alpha (returns) tool, or a money skimmer?
One of the most heated debates between academics and financial analysts is whether quantitative investment can give excess returns for investors. Both have a lot riding on the debate: academics for years have published ideas based around the legitimacy of concepts such as the yield curve, where risk and return correlate, giving investors benchmarks for asset returns. Academics scoff at suggestions that by using unorthodox methods, a manager of a hedge fund could gain above average returns. Although there has been a change in the air, particularly with the American Universities, it’s laughable how dogmatic they remain towards such an idealistic concept. I mean, really, excess returns exist in the real world for every other business industry, provided the individual behind the investment shows quality decision making. Suppose I take an exam with a friend of mine, Tim. We conclude the test, and after marking, we realise that both of us achieved the same score. Does that mean we’re destined to achieve the same results in life? Of course not. Then maybe the result isn’t statistical relevant towards determining our success? Not at all. It provides a good starting point for determining the odds of success, nothing more, and nothing less.
Financial Analysts, however, rarely take part in large public arguments against these academics. Why? In my opinion, there’s two reasons. Firstly, these managers benefit greatly from the existing common perception. Everyone thinks buying and holding is the most optimal strategy. Everyone thinks transaction costs greatly erode gains. Everyone thinks buying and selling on specific news is folly. All those things may or may not be true, but it’s irrelevant; hedge funds benefit of the mere existence of this common thinking. To demonstrate this, what if every single investor was active? How would this change the shape of the markets? We’d see a huge increase in volatility, less trending, more fundamental influence (such as press releases), more panic selling/shorting and most of all, a less vested portfolio. Rather then keeping their portfolios at 100% vested, investors would be more likely to keep a cash element to their asset holdings. Why? So they’ll be ready to buy when an opportunity knocks, of course. All these elements sprinkled into the markets would completely change the analysts and portfolio managers game; it’d go from constructing playing card castles indoors to doing it outside with the prospect of a breeze. In other words, more delicacy is needed, and even a small error in just modest conditions could cause a major blow up.
So, portfolio managers and quantitative geeks from hedge funds like keeping the game, at least on the superficial level, somewhat like what the academics describe, mostly because their models are based on some underlying principles that the academics pedal. That’s not to say that the academics are wrong or don’t know what they’re talking about, but they are based on some loose human psychological assumptions. That fact right there about human psychology can possibly lead to opportunities for the geeks to identify asymmetric market flaws, and capitalise on them.
The second is, as I see it, a pure branding exercise. Hedge funds love being secretive, to the extent of giving themselves a cult like status among the financial world. They love giving their employees 400 page non-disclosure agreements, describing how they can’t even disclose the brand of instant coffee they use. All the hush-hush created intrigues the media; countless stories have been run, pondering the inner workings of these organisations. What voodoo magic are they using? How complex are their equations? How many decimal places can they remember pi too? This works towards luring potential
clients, too. Wealthy investors like keeping their total net worth secret from the mainstream, which seems to suit the unregulated, mystical hedge funds. They don’t want people to think they can do what they do without their expertise. This is the key. The more secretive, the more closed shop, the more mythological hedge firms are, the more it seems like they belong to a special order, a unique group, whom at the wave of a magic wand, can turn seemingly ugly market conditions into cold, hard, returns. Debating academics requires information, data, and explanations. That jeopardises the very important branding. As you can see, the academics may be waiting a little while at the podium before we ever see a hedge fund representative ring that little bell.
Some of you may be asking, what does this have to do with anything? Who cares what academics think, how hedge funds are as much about brand as coca-cola, or why we’ll never see a tooth and nail fight to the death between the two? What about my opportunity in gaining more alpha (return)? I need to maximise my return, damn it! Fair call. So, have hedge funds been proven market winners, or are they just big fat phonies, as EMH supporters would argue? Hedge funds in Australia seem to be comprised of individual investors rather then institutions, which is in contrast to the rest of the world. Hedge funds in Australia also prefer global and regional markets, as opposed to domestic markets, with 71% of investment going outside of this country. We’re all probably getting tired of globalisation cliches, but suffice to say, hedge funds require an investment pool much larger then Australia to work their magic. And do they provide value?
I’ll move to get the formalities out of the way; hedge funds are risky. Very risky. They use strategies which often rely on variables which operate normally 95% of the time; its that 5% that causes problems. We’re seeing that at the moment with the sub-prime crisis. I suspect an asset pricing strategy was to blame for Basis Capital Managements lose during the sub-prime credit fiasco. Although this not a good thing for investors, one must remember the name of hedge funds wasn’t because they were invented inside a maze. Hedge funds exist to hedge against financial movements. If my entire portfolio consists
of one stock in one particular sector, I hedge by buying a stock in an unrelated sector. If I fear a bear market will adversely affect my stock portfolio, I hedge by buying risk free bonds. In other words, I reduce my potential return to reduce my potential loss. Whenever you hear some journalist or academic debunk hedge funds, its because they don’t understand the asset. Hedge funds exist so investors have an alternative asset earner during periods when traditional stock portfolios see sub-standard returns. A great blog on hedge funds is written by a hedge fund industry consultant. Although it is heavily biased towards hedge funds, he makes a very compelling argument for the existence and use of hedge funds by investors. HF makes the argument for why hedge funds are different:
“Hedge funds are NOT an asset class; they are strategy classes. They are a method of managing money that offers a LOWER risk alternative to the traditional holding of assets. They may short sell or buy within and between different asset classes and associated derivatives. Diversification is the only way to spread asset risk; with strategies the depth of risk management tools is considerably more powerful.”
He also compares hedge funds to index portfolio managers:
“Good hedge funds are cheap and index funds are an insult. If anything, the best hedge fund managers are underpaid. Last year, AFTER fees, Boone Picken’s funds did 640% and 89%. The Medallion Fund returned 29.5% AFTER 5% and 44% fees. The “highly respected” Vanguard S&P 500 fund made a derisory 4.77%, had a 50% drawdown a few years back, has not yet made up for those earlier losses and yet charges an egregious 18bp - for what exactly? Long term investors would have done better keeping their money in the bank for 8 years. An index fund “manager” getting minimum wage is grossly overpaid whereas Jim and Boone, relative to their value, are underpaid.”
It’s often cited that transaction costs erode any ‘edge’ hedge funds have over the market. This is a concern, because transaction costs shave both profits and add to losses, greatly harming the cumulative time effect that investing has. The key is to figure out the right mix. Allaboutalpha rightly points out that high managerial and performance fees can cripple a hedge funds ability to give investors returns.
“Once largely overlooked, the impact of realized transaction costs on investment performance is now well recognized. Indeed, transaction costs can substantially reduce, or even eliminate, the notional returns to an investment strategy.”
Like everything else in life though, one must pay a high price for skill. Since no two hedge funds look alike, we can conclude that managerial skill will determine the make up of such portfolios. The right managers putting their hedge funds in a pole financial position is worth paying for. Or alternatively, would you ever trust a bad manager with your money, no matter how little he worked for? Never. It’s up to you, the investor, to look at the pro’s and con’s, the transaction costs, your own financial position, and reach a conclusion about what a hedge fund can do for you.
