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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.
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.