The Tools of the Ultra Rich and Why to Avoid Them

Are Hedge Funds good tools to have in your investment toolbox?

Are Hedge Funds good tools to have in your investment toolbox?

Many think only the wealthiest Americans have access to the most effective asset managers. These Private Equity Funds, Hedge Funds, and Venture Capital firms would have you believe they are brilliant enough to call themselves financial alchemists. The truth is much simpler; these elite strategies regularly fail to match or outperform the broader stock market. Let’s take a look at the performance of these strategies and what inherent flaws are responsible for their failure to beat the simpler approach of investing in low-cost, tax-efficient index funds.

To begin, let’s look at some performance comparisons, in the short-term. Hedge Fund Research regularly publishes data on a broad assortment of hedge funds. One particular measurement, the HFRI Equity Index Hedge, reveals the faltering performance of hedge fund managers. A $1,000 investment in the holdings included in the HFRI would have grown to a little more than $1,050 for the year 2016. In comparison, the same investment in the S&P 500 would have grown to nearly $1,150. In fact, October of 2016 saw the widest gap of hedge fund underperformance relative to the S&P 500 in almost 14 years.[i]

The long-term performance is equally dismal. For the last three years, hedge fund investors have seen their passively managed brethren surpass them. As a result, “Several large institutional investors have publicly announced plans to reduce their hedge fund holdings or to liquidate them entirely as a result of under-performance,” according to Goldman Sachs.[ii]  This under-performance has become the new normal.

Equity hedge funds can certainly stand to shed some weight amid poor performance. The industry is home to $850 billion in assets globally.[iii]  For years these specialized investment techniques offered the beguiling allure of “alpha.” This term represents the degree to which a fund manager delivers growth that exceeds the performance of the broader market. The problem is that alpha has been conspicuously absent from private equity, venture capital, and hedge fund performance. The reasons for under-performance consist of costs, turnover, politics, and correlation. Let’s take a look at each to understand the fundamental flaws.

The most problematic characteristic of these funds is the cost. Commonly, hedge funds command a burdensome “2 and 20” fee structure. Managers receive 2% of the assets regardless of the performance. Additionally, managers collect 20% of the profits after exceeding a predetermined threshold. The mere existence of these fees puts alpha at a greater reach because the investors must earn enough to beat the market and make up for the fee expense. Paying 2% for the privilege to participate in a fund that falls short of the broader market is becoming a difficult proposition. The bigger problem is the 20% fee. Investors are increasingly opting for lower costs as evidenced by the fact that “Some 91% of investors’ assets were invested in funds with an expense ratio less than or equal to 1.19%,” according to a 2015 Morningstar study.[iv]  Moreover, periods of diminished returns are compounded by lock-up provisions. This restriction means an investor is unable to withdraw their funds for a period. One 2012 study determined that the average lockup period is 5.85 months for all single-manager hedge funds. [v]This standard clause ties investor's hands. Between June 30, 2007, and September 30th of 2008, the S&P 500 dropped 40%. That is, in far less than five months values for many were cut in half. Imagine how this impacts someone unable to respond to dramatic downturns. Ironically, while investors are restricted from adjusting their investments managers make many trades leading to the next problem of turnover.

Turnover occurs when managers of a fund buy and sell assets. This measurement is important because such moves generate brokerage fees and tax liability. These costs are not part of the fund’s expense ratio or the “2 and 20” fee structure. Active fund managers are always chasing opportunities thereby boosting costly turnover. Annual data between 2002 and 2015 shows that actively managed funds experience ten times more turnover than passive funds.[vi]  As a result, the average active fund turnover is 32% while the average passive turnover is just 3%. Despite its importance, turnover is not commonly measured or reported. This lack of insight leaves investors in the dark. Additionally, the problem of fund turnover is exacerbated by the poor decisions driving the regular buy/sell activity. For too long managers have looked exclusively at economic data (e.g. central bank policies) rather than the political landscape for clues.

Politics have become a greater influence of market movement than ever before. The UK Brexit referendum was an upheaval to the FTSE 250 which plummeted after the vote. Recently, renewed fears of a French exit from the EU (“Frexit”) have sent investors fleeing to the relative safety of gold, sending prices to a three-month high as of February 7th. Hedge funds have failed to consider the impact of a Trump victory on the market. The S&P 500 soared on the news of the new administration and hedge funds flopped. Managers misjudged the market in both the technology and financial sectors. As Marketwatch reporter Ryan Vlastelica explains, “Going into the election, hedge funds in aggregate had large positions in technology shares—one of the weakest-performing industries since the election—and smaller ones in financials, which have been the market’s best-performing sector over the past two weeks.”[vii]  Even Hedge Fund Research President Kenneth Heinz remarked that managers “didn’t think enough about it and were victimized by wild swings in policy and uncertainty.”[viii]  An increasingly nationalistic movement across the globe will only add to the exhaustive list of metrics hedge funds must manage. This challenge is important because active management requires insight to the dispersion of stock market prices leading to the final problem of reduced correlation.

Active managers make money betting long and short on different movements among stocks. However, a recent phenomenon has made this practice more difficult. The correlation of stock performance within like sectors has increased “leading to lower dispersion of stock performance,” according to Goldman Sachs.[ix]  This change comes amid index fund inflows thereby causing stocks to rise and fall in unison rather than based on company-specific fundamentals. As more investors awaken to the value of a passive strategy index fund holdings grow. As a result, the growth of the funds becomes more a function of mounting investments rather than company fundamentals (Read: “The Swinging Pendulum of Passive Investing”). Moreover, international and U.S. stocks have experienced increasing correlation since 1980.[x]  This global trend leaves fewer opportunities for managers to exploit discrepancies in the market. The trend is likely to continue given that “In the last year, all categories of long-term active funds lost a staggering $308 billion, while passive funds (again, largely ETFs) attracted $375 billion.”[xi]

Given the inexorable problems of cost, turnover, politics and rising correlations it’s no wonder these outflows continue. Studies repeatedly show that a low-cost, tax-efficient index strategy is the reliable way to accumulate wealth over the long-term slowly. The four problems with hedge funds discussed here represent some of the strengths in passive investing. That is, costs are low. Turnover is also small as a passive strategy just mirrors an index. The diversification across sectors helps insulate against political risk. Finally, rising correlations are less of a risk as passive funds do not seek to play one stock against another. While commitment may be difficult the strategy is easy; stay in the market, minimize costs, diversify and avoid timing. As Warren Buffet said, "Investing is simple, but it isn't easy.”

Sources

[i] http://www.goldmansachs.com/our-thinking/public-policy/directors-dilemma-f/report.pdf

[ii] Ibid.

[iii] Fletcher, Lawrence. Hedge-Fund Managers Bombed in ’16. February 7, 2017. WSJ

[iv] https://news.morningstar.com/pdfs/2015_fee_study.pdf

[v] https://www.preqin.com/docs/newsletters/hf/Preqin_HFSL_Dec_2012_Liquidity_Structures.pdf

[vi] http://www.goldmansachs.com/our-thinking/public-policy/directors-dilemma-f/report.pdf

[vii] http://www.marketwatch.com/story/hedge-funds-have-mostly-missed-the-trump-rally-2016-11-22

[viii] Fletcher, Lawrence. Hedge-Fund Managers Bombed in ’16. February 7, 2017. WSJ

[ix] http://www.goldmansachs.com/our-thinking/public-policy/directors-dilemma-f/report.pdf

[x] https://www.blackrock.com/investing/resources/education/alternative-investments-education-center/why-should-i-use-alternative-investments/increased-correlation

[xi] http://www.cnbc.com/2016/06/27/more-investors-are-making-the-switch-to-passively-managed-etfs.html