If you regularly read trading/investing/personal finance stuff, there is a high chance you would, at least once, have stumbled across a title like “Hedge Funds underperform and yet continue to attract capital from investors”.

At first (which means 20 years ago) the topic was interesting from a behavioral point of view. But now it basically became a spin-off of the mainstream genre of “Rich people are so stupid, let’s laugh about it”; a less entertaining, and funny, version of Succession or The While Lotus applied to a less entertaining, and funny, subject. Let’s be honest, 99% of the readers will never get the chance to invest in a hedge fund; you do not write about the fact that Rihanna has bad breath because you want to alert your readers: there is zero chance any of them will ever exchange one word with her in their life, figure having to deal with an awfully early morning hey you from the other side of the bed. You do it because you want them to feel better…and get some clicks in return.

Analyzed the right way, the subject is indeed insightful and valuable. Even for folks that would never get the chance of dating Rihanna. Plus, under my professional hoodie I had to, tangentially, deal with it (investing in hedge funds, not dating Rihanna). I can bring some views that are rarely discussed.

Hedge Funds are just a Vehicle

There is a lot of confusion between HF as an “investment strategy” and HF as a “regulated shoebox”.

Regulations rule everything around us. If you want to manage money for yourself, you have to abide by certain regulations: what you can put in your shoebox, is largely linked to how much money you have. If you want to manage money for others, you can use different shoe boxes: each one comes with a set of rules, instruments you can use and disclosures you have to make. Mutual funds, ETFs, HFs are just different types of shoe boxes. HF regulations allow money managers a degree of freedom that is (sometimes used to be) higher compared to other shoe boxes. But that’s it. From an investment strategy point of view, there is nothing that points to HF as being more clever, riskier or… less risky; the only constant (maybe) is that they tend to be more expensive than other boxes.

Originally, they got the name ‘hedge’ funds because they were supposed to be less risky than traditional mutual funds. But they were also allowed to use tools, like leverage and shorting, that are considered (rightly or wrongly) to be riskier. Flash forward to today, mutual funds are dying like common sense among ESG proponents and ETFs can use almost any tool available for HF.

Defining something as an HF, without specifying what is inside that specific shoebox, tells you only one thing: you, poor bastard, cannot buy it. That’s it.

Grouping Hedge Fund Returns is bulls&%t

Your typical diss against HF includes a table like this one:

Grouping HF returns like this is like bringing a bunch of people to a restaurant that serves “random things from the sea”, anything from whales to urchins to algae to used boots, and average their meal satisfaction. It makes no sense.

While no two hedge funds are the same, most generate their returns by investing in line with a specific top-level strategy: equity, relative value, event-driven, macro, credit, CTA, and alternative risk premia. 

Even within the same strategy, the dispersion of returns is big:

I am not implying that anyone is able to pick the best manager in each strategy but that, even if you want the average return, you cannot get it. There is no way to have a beta exposure (unless you buy many funds in the same category, something that not even fund-of-funds do): at the end of the day, you might do better than that average, or worse…but you will hardly achieve the average.

No Alpha

This is the most valid remark regarding hedge funds: some managers do generate alpha but it is really hard to find them (before the fact, after it is pretty easy ;)). The task is even more complicated for two reasons:

  • some alpha strategies get arbitraged away. Ed Thorpe formulated the option pricing model before the guys that got the Nobel prize for it; he kept it for himself and made a lot of money. Once the formula was published by Black and Scholes, Thorpe edge disappeared. Alameda was buying bitcoin in the US and selling at a premium in Japa…ah no, sorry, they were just a fraud. Anyway, I hope you got the idea.
  • while losing managers are always happy to get funds, managers that consistently produce alpha sometimes close the shop to external investors. Infamous examples are The Medallion Fund and BlueCrest. These cases are more painful for investors because they found the right horse…and they cannot ride it anymore.

It is a very close argument to the active vs passive investing debate. Based on my experience, there are some situations where going active makes sense. Let’s say we want to invest in Emerging Markets debt. We can either take a BlackRock passive index or an active manager (remember we are an Institutional Investor, me and you cannot invest in HF anyway). The main selling point for going active is that passive indexes are ‘dumb’, they invest in Argentinian 100-year bonds just because they are issued, even if Argentina defaulted on its debt more often than I get to go out with my friends after we had kids.

Passive indexes are dumb indeed! And yet, active managers cannot beat them on a consistent basis. On the other side, active managers reply to your emails while passive indexes, and their providers, don’t. Last year in EM we had the Evergrande default in China, the Lebanon default, the war in Ukraine and…other things that now I do not recall (something in Ecuador for sure). If you have someone that can explain to you what is going on, hold your hand, you (and the business you work for) are more likely to stay the course and not panic. You can concentrate on what you do best and avoid wasting time researching who the current Lebanon PM is (the father of a girl my wife worked with…but this is the story for another time). The 0.5% (including fees!) that you lose choosing to go active might indeed be a saving compared to the scenario of selling into a panic and tinkering continuously with your asset allocation.

There is no Beta

What the Hedge Fund debate misses completely is that some asset classes have no beta. Even in the smart beta world, David Einhorn’s performance cannot be ‘cheaply replicated’ with a value index because his portfolio is so concentrated that David is both the alpha and the beta. Either you want exposure to David, or you do not. There is no middle way.

So why would you want to invest with the Davids of this world, if there is evidence that, on average, they underperform?

Because the comparison with the S&P500 is totally stupid

Annualized returns are important but they are not the whole story. Comparing something with the S&P500 returns without mentioning that to achieve it you have to stomach 20% volatility and drawdowns higher than 50% is not legit. Some folks that are already rich (remember, they can access HF) might be interested in just staying rich, not becoming richer. Investing in a strategy like the Cockroach Portfolio might be fine for them because they care more about downside volatility than returns.

Because pairing the S&P500 with something that is uncorrelated to the S&P500 creates a portfolio that is better than the S&P500 alone

Trend strategies do wonders when paired with stocks. $DBMF is one of the first attempts to create a low-cost, beta trend strategy but until yesterday (and maybe also tomorrow, as the jury is still out to determine if their strategy works long-term) you could only access them via hedge funds. The point has never been to invest 100% in that trend HF manager (what the returns comparison suggests) but to use different building blocks to achieve an improved risk/return profile.

A few days ago I was reading this post from Monevator where they mentioned the UK-listed macro hedge fund BH Macro Global. The Bloomberg description page does not even mention the fund fee but they must be MORE than the 2-and-20 (2-and-20 are the underlying HF fees, the closed-end fund listed in the UK has most likely its own fee on top of those). Shall I care about that or about this:

BH Macro Global is the white line and the performance is net of fees

The fund underperformed the S&P500 but look at March 2020 or last year: that’s what these products are for (and what you hope to pay for). According to AQR, you “can double a portfolio’s long-run Sharpe ratio with four uncorrelated strategies. Further analysis of trend following—and its cousin, macro investing—makes it look like a particularly good complement to common investor portfolios that are dominated by equity risk. Not only have these strategies offered a positive long-run return and good performance amid equity market drawdowns, but they also have tended to perform well at other times of trouble for the core portfolio: Fed tightening, high volatility, and large moves in inflation up or down”. Yep, AQR manages Hedge Funds. Yep, I would invest with them if I could.

Kris Abdelmessih recently went on a bender on the difference between arithmetic and geometric means: “So when someone says the stock market returns 10% per year because they looked at the average return in the past, realize that after adjusting for volatility and the fact that you will be re-investing your proceeds (a multiplicative process), you should expect something closer to 8% per year.” Reading his posts reminded me of this old essay on ergodicity from Taylor Pearson. The more you lower your portfolio volatility, the more you shrink the gap between its arithmetic and geometric means…which means future returns have a higher chance to resemble the past.

I listed some rational motives for why investors look at hedge funds. Let’s close with a very bad reason that might be not so evident to the general public.

Consultants

Many successful entrepreneurs and institutional investors use investment consultants. Sometimes because they do not have ‘internal’ expertise, sometimes because they think is cheaper, sometimes because they want another layer of hand-holders (experts that can confirm the firm/entrepreneur is doing the right thing).

The other day a friend that works in the marketing department for an asset manager asked me how I screen for ETFs. The first thing that came to my mind was “I use Vanguard and follow a couple of dudes on Twitter”. It is true, if you are not an expert (or mad like me) it is a jungle out there. If you have to deal with mutual funds, private funds and hedge funds as well, finding what you are looking for is basically impossible. That’s when consultants come into the picture.

The first goal of a consultant is to keep their job, i.e. you as their client. Not to increase your returns or reduce your losses. That comes after their second goal, which is to increase the commission you pay them (upselling). They will push you towards hedge funds & co. (private equity, private debt, infrastructure) because:

  • they know you read about that fund that scored big last year or your competitor that has an amazing portfolio. They cannot tell you the hard truth because they risk losing you to another consultant ready to sell the dream you are eager to hear (“our proprietary research can find you the next big thing”).
  • Not only they can screen the good managers from the bad, they have ACCESS to them. And they will negotiate a special fee discount for you.

If investors have their own behavioral issues, consultants are like gasoline poured on that fire. [I mean, if you are the banker of a newly minted billionaire entrepreneur, try to convince him that chasing a hot fund is a fool’s errand without losing the relationship].

What I am reading now:

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