I guess this Bloomberg Businessweek cover story is very real and we have to talk about it. So, here you go, tell us in the comments how you feel about how Businessweek feels about your manhood. Be sure to reference the fact that the title of the story is “Hedge Funds Are for Suckers.” My own reaction seems best suited for a footnote.1

The story seems weirdly timed to alienate hedge funds just as they’re being allowed to start buying advertising, though I guess that doesn’t matter because they were all going to spend 100% of their advertising budget on Dealbreaker and give Businessweek a miss anyway. And it tells a pretty familiar story: once, hedge funds were small smart places that produced steady uncorrelated returns with significant positive alpha. Now, every idiot who wants to tweet lies about hurricanes or be an asshole on online dating sites is a “hedge fund manager,” and a lot of them don’t manage very well:

In a 2011 paper that he updated this year, Roger Ibbotson, a finance professor at the Yale School of Management who runs a hedge fund called Zebra Capital Management, analyzed the performance of 8,400 hedge funds from 1995 to 2012; he concluded that on average they generated 2.5 percent of precious alpha. “They have done a good job, historically,” Ibbotson says. “Now, I think it’s overcapacity. I doubt that the alphas are completely gone, but alphas are going to be harder to get in the future than they have been in the past.”

Here’s the 2011 paper, which decomposes hedge fund returns and finds pretty much beta > fees > alpha > zero, for one simple definition of “alpha” that equals more or less “outperformance versus a certain mix of stocks and bonds.”2 Businessweek implicitly uses an even simpler view of alpha, and is disappointed: “According to a report by Goldman Sachs released in May, hedge fund performance lagged the Standard & Poor’s 500-stock index by approximately 10 percentage points this year.”

One reason to be optimistic for hedge funds is that they’re not particularly marketed as “beat the S&P 500!” I mean I guess long equity funds are. Sure, SAC is hurting. But for instance here is the manifesto of a large and well known (now somewhat downtrodden!) hedge fund:

Betas in aggregate and over time outperform cash. There are few ‘sure things’ in investing. That betas rise over time relative to cash is one of them. Once one strips out the return of cash and betas, alpha is a zero sum game. If you buy and I sell, only one of us can be right. The key for most investors is fixing their beta asset allocation, not trading the market well.

That’s not “we’ll use our giant penises to find you tons of excess return over the S&P.”

You could build a simple model that goes like:

  • over long time periods equities should go up by more than most other asset classes;3
  • anyone not 100% in equities won’t capture 100% of that beta;
  • alpha is zero-sum so if you have a bunch of people actively trading their average performance won’t be better than the market performance; and
  • fees! Big fees!

Which leaves you with “if you want equity returns putting all your money in a random bunch of hedge funds is dumb.” Which you probably knew already? I mean, you did; lots of people probably don’t and will be suckered by hedge fund advertising. But mostly the people investing in real hedge funds know it. Like, the pension funds in All Weather are not looking to beat the S&P.

Mutual funds advertise pretty boringly, as far as I can tell. It’s like “we have nine funds with Morningstar five-star ratings,” which is pretty much always true, because Morningstar five-star ratings are basically randomly distributed. All they mean is that you beat your benchmark, and that is the result of a random number generator, so if you have enough funds and enough time periods to choose from, you will have some five-star funds, and then go market those. 100% of what you are selling is alpha, relative to a simple market-standard benchmark for your category, and the nature of alpha is that someone always has it though you probably can’t figure out who it’ll be next year.

That worked for a while but people are slowly realizing that it’s kind of a scam and they should just index, so they increasingly are. This isn’t great for the mutual fund industry – whose own overcapacity and alpha generation record don’t get a mention in the Businessweek article, though to be fair their fees are lower – and is leading to nontraditional forms of mutual fund advertising based on folksiness rather than alpha.

Hedge funds, I feel like, don’t have this problem? They started with the folksiness; the turn to “beat the S&P 500 with a hedge fund!” seems like a momentary boom-time aberration rather than a fundamental feature of the investment class. Like, yes, if you’re advertising based on beating the S&P a lot, you’d better beat the S&P a lot. But you can tell a lot of other stories – stories of uncorrelated returns, or of risk parity, or of alpha generation on a factor model that matters to your investor. You’re not held to a fund-category benchmark. You’re held to what you can sell, in your private meetings with investors.

Nobody really thinks the big hedge fund firms will start advertising as soon as it’s allowed, and you can see why not. Advertising means, basically, telling investors that you can beat the market, and how many managers can say that? Hedge fund marketing means persuading investors that you can do a thing, and also persuade them that that thing is worth doing. Which is not at all the same thing.

Hedge Funds Are for Suckers [BBW]

1. As I’ve mentioned before, when I worked in banking I kept a collection of Worst Pitchbook Pages and was always looking for additions. One surprisingly common subcategory featured hypothetical stock-price paths – to illustrate trading strategies, derivative mechanics, whatever – that curved back on themselves. This sort of thing:

Stock prices don’t do that: you can’t have one stock with two prices at the same time. (Also: Excel can’t really do that, meaning you generated your illustrative stock price graph by drawing it, which is suspect on its own.)

My reaction to the limp-dick line on the Businessweek cover was, thus, naturally enough, “that’s not a function!” Though of course they never said it was an asset price path. I guess it’s just a penis.

2. Viz., like, alpha = return – (beta to S&P 500) – (beta to intermediate-term treasuries) – (beta to cash). There’s discussion of “nontraditional betas” but the focus is on those three.

3. Risk premium etc. etc.

34 comments (hidden to protect delicate sensibilities)
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Comments (34)

  1. Posted by guesto | July 11, 2013 at 11:53 AM

    Dang! Dat guy's got two weinuhs!

  2. Posted by Guest | July 11, 2013 at 11:57 AM

    OK, I confess: I am with Matt, my first reaction to the cover story was also "share price graphs can't curve back on themselves".

    – Guy whose mind is stuck in the gutter of his college mathematics textbook

  3. Posted by Han_Jobe_Solo | July 11, 2013 at 11:58 AM

    Snap! Bloomberg be hatin!

  4. Posted by Anihilist | July 11, 2013 at 12:02 PM

    "Can I please order 500 copies of the latest edition of Businessweek?"

    -L. Tilton

  5. Posted by Guest | July 11, 2013 at 12:07 PM

    Comp for adding little or no value at a hedge fund > comp for adding little or no value at Bloomberg Businessweek

  6. Posted by Im_a_Dude | July 11, 2013 at 12:26 PM

    He's actually pissing blood from all the oxy and other shit he's been taking…

  7. Posted by Bird Watcher | July 11, 2013 at 12:27 PM

    Look at the giant pecker!

  8. Posted by Engorged | July 11, 2013 at 12:30 PM

    In this context, I suppose bent dicks are a good thing. An extra pop at the end!

  9. Posted by Guest(s) | July 11, 2013 at 12:35 PM

    We are long 2017055Z LN Equity.

    – J. Paulson

  10. Posted by BBerg Benefits Quant | July 11, 2013 at 12:40 PM

    I heard they've started offering free counseling for when a former GS VP fucking around in his spare time makes your whole journalistic enterprise look like a bunch of idiots.

  11. Posted by John Rocker | July 11, 2013 at 12:49 PM

    You think that's bad? You should see the graphs for Asian focused funds.

  12. Posted by Guest | July 11, 2013 at 12:50 PM

    I hope that photo is actually of a real banker somewhere that didn't know what the picture was for and not just an actor.

  13. Posted by Guest | July 11, 2013 at 1:06 PM

    Are we sure that the chart in footnote 1 isn't Jack Lew's signature?

  14. Posted by Guest | July 11, 2013 at 1:14 PM

    There is a limited group of people who actually outperform the market with any level of consistency. Every couple of decades or so they change the name of what it is they do, the last time to hedge funds.

    The market then realizes – hey, excess returns and piles in, followed shortly by a lot of other fund managers who look at where the money is going and say – oh, yeah, we're that too, here's a squiggly line that proves it, millions in fees please..

    Of course their returns suck and over time you get articles like this one. So, my reaction – what should the new name be?

  15. Posted by Conan the Destroyer | July 11, 2013 at 1:14 PM

    When the size of your perceived cock exceeds the actual length, that is what we call contango my friends.

  16. Posted by Guest | July 11, 2013 at 1:52 PM

    Its pretty common for one's penis to have multiple prices at any one given point in time. The sales price depends heavily on who the buyer is.

  17. Posted by Paulson | July 11, 2013 at 2:10 PM

    Fuck You All! GOLD IS COMING BACK, BITCHES!!!!

  18. Posted by DB Ad Salesman | July 11, 2013 at 2:31 PM

    "I mean, you did; lots of people probably don’t and will be suckered by hedge fund advertising."

    Matt, how the fuck am I supposed to sell banner ads to hedge funds after you say the ads won't work on our readers?

  19. Posted by CAPM | July 11, 2013 at 3:41 PM

    Shake 'n Bake

    -Ricky Bobby Capital Partners, GP

  20. Posted by Woof | July 11, 2013 at 3:50 PM

    My reaction is that you're overthinking this.

  21. Posted by Jon Corzine | July 11, 2013 at 4:07 PM

    Advertising is key. At MF Global, we didn't advertise our 50x leverage Greek debt fund properly, which is why we failed.
    – JC

  22. Posted by Guest | July 11, 2013 at 4:08 PM

    Being allowed to start buying advertising?! So only Kenny G and his earth quake fault line was allowed to advertise up until now?

  23. Posted by TheodoreBallgamePhD | July 11, 2013 at 4:20 PM

    "If you ain't first, you're last."

  24. Posted by Texashedge | July 11, 2013 at 4:33 PM

    Anyone long nat gas just laughed at your comment then threw up a little.

  25. Posted by Texashedge | July 11, 2013 at 4:40 PM

    I'd really like to read Matt's coffee table book "Worst Pitchbook Pages"

    I imagine the cover would be a league table with just one name on it.

  26. Posted by Max G | July 11, 2013 at 8:37 PM

    I love dealbreaker, read everyday, and it pains me to have to point this out the glaring error in this article.

    Bridgewater's All-Weather Fund is not a hedge fund, rather it's a strategy run by a hedge fund. the All-weather Fund is Bridewater's "risk party" strategy which is nothing more than a risk budgeted asset allocation fund. The proverbial invest and forget it–unless of course May comes around and you have levered exposure to bonds. Check out their Pure Alpha returns and you will see how they actually do.

  27. Posted by Matt Levine #1 | July 11, 2013 at 8:56 PM

    And it's his.

  28. Posted by Bill Ackman | July 11, 2013 at 10:58 PM

    anyone have any spare change?

  29. Posted by Commenter | July 12, 2013 at 9:54 AM

    We'd prefer it if you just stuck with the reading part.

  30. Posted by Guest 5 | July 13, 2013 at 11:21 PM

    I think its "risk parity" not "risk party".

  31. Posted by Guest | July 14, 2013 at 10:18 PM

    I saw Ackman at dinner tonight, Lincoln Square area. So much for the theory that only losers are in Manhattan on summer weekends.

  32. Posted by Finkle | July 15, 2013 at 3:05 PM

    No, the theory still holds…

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