One of the more, shall we say, interesting magazine covers showed up on my desk yesterday. Not, as you might expect, the Rolling Stone cover, which is simply a contemptible bid for publicity. No, I’m referring to the Bloomberg BusinessWeek cover, which displayed a somewhat graphic, at least on an implied basis, picture and graph.
The headline on the cover is “The Hedge Fund Myth,” and the cover story spends quite a bit of time excoriating hedge fund managers for making lots of money and not deserving it.
The author makes several good and cogent points, which, unfortunately, are located near the end and come after a great deal of fire directed at wealthy hedge fund managers. I want to spend some time looking at those valid points, but first let’s deal with the nonrelevant ones.
The title of the article, “Hedge Funds Are for Suckers,” says it all. Managers, according to the author, are ripping off investors for two reasons. First, what they do is impossible, and, second, they are charging too much for it. Reminds me of the old joke, “The food here is terrible, and the portions are too small.”
Let’s start with the impossible task argument. At its core, and stripped of the comments on “obscene wealth” and “would-be financial hotshots,” the article is an attack on the very concept of active management. In fact, the author states this explicitly: “This means that trying to gain what traders call an ‘edge,’ at least legitimately, is almost impossible.” If this is the case, then active management is a waste of time, for all investment vehicles, and everyone should be in index funds. The problem is that if an investor believed this, he or she would not be in hedge funds in the first place.
Academics typically believe that the markets are efficient—that all available information is incorporated into security prices, so active management cannot make money. Practitioners, on the other hand, are more apt to believe that the markets are inefficient and that there is a place for active management. Empirical evidence, in the form of many multi-billion dollar funds with long and verifiable track records, suggests that the practitioners are right. James O’Shaughnessy’s book, What Works on Wall Street, is a good review of some of this empirical evidence. So, the notion that active management is impossible has, in my opinion, been refuted.
There remains the notion that hedge funds, in some way, are illegitimate. The problem with this is that the very idea of a “hedge fund” is somewhat vague. Is it the underlying investment strategies? Is it the private legal structure? Is it the fee arrangements?
There is no consistent hedge fund definition. In terms of strategy, many hedge funds use strategies that are now available in retail wrappers. Does the use of a strategy in a mutual fund format make it okay? As for private investment partnerships, how does limiting access make it wrong? As for fee structure, if the compensation model is the real problem, which piece? The fee as a percentage of money managed? A fee for success? Both look like proper alignment of incentives to me, with the manager rewarded for making his investors’ money, which, in fact, is how the managers mentioned in the article succeeded.
If we look at the managers specifically taken to task—Simons, Soros, and Griffin, among others—the fact is that for many years, they provided superior returns. That’s why they attracted the money they did. Mutual fund managers have done the same thing, although with fewer zeros in their compensation. In fact, as I read the article, if I replace “hedge funds” with “actively managed mutual funds,” much of the narrative still remains consistent. After all, both mutual funds and hedge funds are attempting to do the same thing—use brainpower to get superior returns.
None of this is to defend hedge funds, but simply to suggest that although there are valid concerns, how much money the managers make shouldn’t be one of them. It is when we set aside the manager compensation and structural issues that we come to the very valid points of the article—about why returns may have eroded in recent years and how investors should be aware of this.
What we should be aware of is that any strategy, when successful, will attract more capital and erode returns, and here is where it gets interesting. Strategies to beat the market do exist, but as they succeed and become more visible, returns get eroded to zero. Over time, the market becomes more efficient, and new strategies become necessary. Most recently, we have seen this with the high-frequency traders, whose profits are eroding even as we speak. Active management can work, but it is a Red Queen’s race: you have to run as fast as you can to stay in one place. This, frankly, is universal in the investment world; it’s not limited to hedge funds.
The example I use is a poker game. One pro with nine recreational players will make a good living. Two pros, also okay. Nine pros at a table is a tough game. We may well be at a nine-pro level for many hedge fund strategies, and investors should be aware of this.
The valid points of the article—that investors should first understand what they are investing in and then judge whether it is a valid and sustainable strategy—apply to all investments, not just hedge funds. This is a big part of the due diligence Commonwealth’s Research department does for our advisors. I will note that the article’s discussion of hedge fund incentives is very valid—and something we look at here as well. The phases of hedge fund life are also dead on. Again, though, this applies equally to other investment vehicles.
The ultimate takeaways from this article are pretty basic. Know what you own and how you expect it to perform. Investigate and understand your managers. And be prepared to pay for success. After all, if you object to investment managers making lots of money, just invest with poor ones—they make very little.