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Hedge funds tell a great story

Weekend reading

Good reads from around the Web.

Why don’t hedge funds just track the indices? I mean this as a (semi) serious – albeit rhetorical – question.

On a rolling basis the returns from their current methods look lousy, as we were reminded again this week by FT Alphaville:

…stock-trading hedge funds had produced returns of just 8.7 per cent total in the previous three years.

Though it’s a shame the S&P 500 is up two-thirds, with dividends, since the end of 2009.

On the face of it a hedge fund could just track a stock market index and cream off its 2/20% cut, and beat most of its rivals.

But in reality things aren’t so simple.

For starters it’s not really fair to compare a basket of hedge funds with a pure equity index. While I’m skeptical of the wider claims for the hedge fund industry, I concede some do hedge, some may achieve absolute returns year-on-year, and some do deliver uncorrelated returns.

True, even those that do will probably be beaten by a simple 60/40 equity/bond ETF combo, after fees, but the point is you can’t really compare an equity index in a bull run with a wider variety of trading strategies.

Oh yes, fees. That’s a bigger reason. Passive indexing works mainly because it’s cheap. If a hedge fund holding just index funds still syphoned off one-fifth of their investors’ returns, they’d by definition still do much worse than pure index investors.

But I think the biggest reason is probably marketing.

Total money invested with hedge funds continues to grow not because their returns are good, but because the story is:

Hedge funds can’t tell their investors they will simply hold mix of passive funds and rebalance, because nobody is going to pay up for that – even if the results are comparable.

No, people like to think they’re different, special, and deserving of special insightful managers. They will pay to be indulged in their fantasies.

For as long lives such delusions, so will hedge funds.

(So, forever then).

From the blogs

Making good use of the things that we find…

Passive investing

  • Explaining the ‘it’s different for me’ mentality – Rick Ferri
  • Indexing is a great financial innovation – Vanguard blog

Active investing

Other articles

Product of the week: Lenders are making it easier to get a Buy-To-Let loan, according to the FT [search result]. Natwest currently tops the tables with a 2.69% rate for deposits of 40% or more. There’s a £1,995 fee.

Mainstream media money

Some links are Google search results – in PC/desktop view these enable you to click through to read the piece without being a paid subscriber of that site.1

Passive investing

  • Ex-hedgie now on an indexing crusade… – Index Universe
  • …and a podcast interview with the same chap – Motley Fool
  • Why not just buy Buffett? – Swedroe/MoneyWatch
  • Investors leave billions on the table – WSJ [via Mike]
  • Five more big mistakes that investors make – Forbes

Active investing

  • Terry Smith’s ‘simple investing’ has delivered – Guardian
  • Go active or passive in small caps? – Index Universe
  • Bond funds are due a bad surprise – MorningStar

Other stuff worth reading

  • Strange tales from London’s property market – Guardian
  • Investing legend Peter Lynch now gives away his money – N.Y.T.
  • Millionaire Martin Lewis shops in Poundland – Telegraph

Book of the week: A final plug for Investing Demystified seeing as its author, Lars Kroijer, is interviewed twice in the passive investing links above. It’s the best Tim Hale rival out there for UK passive investors.

Like these links? Subscribe to get them every week!

  1. Reader Ken notes that: “FT articles can only be accessed through the search results if you’re using PC/desktop view (from mobile/tablet view they bring up the firewall/subscription page). To circumvent, switch your mobile browser to use the desktop view. On Chrome for Android: press the menu button followed by “Request Desktop Site”.” []

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{ 11 comments… add one }
  • 1 Willem de Leeuw November 9, 2013, 1:18 pm

    I thought the point of a hedge fund was that it was to be hedged i.e., if the market tanks you won’t be taken as far with it as you would with a tracker? Despite the popular myth, active investing doesn’t have to be about beating the market, earning a reasonable rate of return with a lower beta is enough for many, usually via a classically balanced portfolio.

    (I’m not recommending buying hedge funds btw, I think they’re too expensive.)

  • 2 Willem de Leeuw November 9, 2013, 1:20 pm

    Ah, sorry, you touched on this. I shouldn’t have skimmed the article so quickly.

  • 3 Frugal Sage November 9, 2013, 1:42 pm

    Why do most people buy anything? Or at least spend more on a product compared to another comparable product. It comes down to either product quality or marketing.

    Coke Cola over Pepsi. The markup difference between them is huge, but people still buy coke.

    For the average person, I think the “different, special, and deserving of special insightful managers” has less to do with it compared to the sales pitch.

    “When the market drops 20% you’ll lose 20% in an index fund”. vs “We can hedge on the downside”. Most people will take that as making money no matter which way the market goes. But it doesn’t. Anyone who buys an uncorrelated asset like bonds “will hedge on the downside”.

  • 4 gadgetmind November 9, 2013, 2:38 pm

    I can see how those who invest in a portfolio of trackers and bonds can lose capital over the short term (even though they win over the long term.)

    I can see how those who invest in hedge funds may occasionally win over the short term (even though they under-perform in the long term.)

    But under what circumstances can those who run hedge funds lose?

    The best way to win seems to be to sit on the sidelines and keep extracting pounds of flesh from those who do have skin in the game.

  • 5 Linton November 9, 2013, 11:13 pm

    I think in the Hedge Fund article you are making the mistake of over-interpreting short term data. The past 3 years have been very different from the pre-crunch period. Safe dividend paying shares have performed spectacularly well, my HYP-ish portfolio has averaged over 17% annual IRR which is rather better than a FTSE Allshare tracker. That sort of return is more what one would expect from a growth portfolio in the good times. Conversely some of the growth areas have performed rather badly.

    So I would suggest that the large differences in performance between a broad market tracker and hedge funds is more a function of the economic situation and the sectors these quite different sorts of fund invest in than evidence of some inherent superiority of one strategy over another. You need a lot more data covering a much wider range of conditions to justify that sort of conclusion.

  • 6 dearieme November 10, 2013, 1:35 am

    “saving for us would take a lot longer and harder than paying off a card”: sometimes the limiting factor is just bovine stupidity.

  • 7 pkora November 10, 2013, 10:03 am

    Who is buying these hedge funds? Institutional, pension funds or some one else. Are these people buying in to hedge funds that are actually doing well or the guy with the best story. Do hedge funds have any correlation to the market and act like a diversifier as bonds do. I would not expect bonds to give me the same return as equities so i do not know whether we should expect hedge funds to do that either. How have hedge funds fared when comparing bond returns ? Would you say that hedge funds are not separate asset class to both bonds and equities and do not offer any advantages

  • 8 dearieme November 10, 2013, 12:02 pm

    One of my final salary schemes now has 18% in “alternatives”. Presumably it’s too late for the ball.

  • 9 Rob November 10, 2013, 1:28 pm

    Most hedge funds lack the performance of an index tracker, but the main issue is whether they have a place as a portfolio diversifier. From what I’ve seen they have a moderate correlation to broad market equities. I think most people would have better luck diversifying with bonds, property and commodities though.

    I see Tim Hale’s book is now in 3rd edition – is there anything new from the 1st ed. which I read a while back? It was the book that got me started with passive investing, so I’d be interested to hear of any new insights. But I can’t imagine there’s that much new to say…?

  • 10 chris November 10, 2013, 3:18 pm

    hi, i would like to know, if you think that a hedge fonds etf is a asset class of its own, that could help do diversify a passive etf portfolio? thx, chris

  • 11 Tufty November 10, 2013, 5:38 pm

    Another great article. Im sold. The only fund Ive made any money out of is Invesco High income!

    What’s the minimum that I would need to invest in an index tracker (specifically Vanguard LifeStrategy 100% Equity bought via Hargreaves) to make the costs worth it? For example, Vanguard charge 0.33% annually, and HL charge £24pa. So investing £200 just isnt worth it. Would a £2k initial investment be worth the fees? Id hope to pay in more over time (hopefully monthly). Im 40 years old, so maybe I should go for the Vanguard LifeStrategy 60% tracker?

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