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Weekend reading: How will hedge funds sell their rotten performance?

Weekend reading

Some good reads from around the Web.

Every now and then someone pats me on the head and tells me I don’t understand that the real smart money is in hedge funds.

They might tap their nose and explain you have to be “in the know”. More than once they’ve been in the know for about six months – or in fact they aren’t invested in hedge funds at all, but aspire to be. I’ve not come across many long-term hedge fund promoters.

While I believe passive investing is the best choice for most people, I am far from a pure passive investor myself. Nor do I think all hedge fund managers are stupid – quite the opposite. More Money Than God was one of my favourite reads of last year. There was much financial high adventure to thrill to from the hedge funds profiled, even accounting for survivorship bias and so forth.

But I liked that book – and I invest in my own stock picks – because I am vain, self-deluding, and greedy enjoy the challenge of trying to beat the market, not in the sure expectation of doing so.

In contrast, there’s no reason to invest in an actively managed fund except in the pursuit of higher gains. Passive funds will give you diversification more cheaply, and more accessibly. And unfortunately for all concerned, the majority of managed funds fail to beat the market, not least because of the fees they charge.

Which brings us to hedge funds. Time and time again we’ve seen evidence that most cannot consistently jump over the hurdle of their “2/20” fees in order to deliver value for investors over the long-term.

They didn’t even do very well in the period spanning the last stock market crash, lagging a cheap tracker/bond combination. Their much vaunted defensive ‘hedge’ proved as illusory as a Quaker Gun.

For many years, hedge funds have been unable to advertise in the US. Supposedly only sophisticated and rich investors were capable of understanding why it was a good idea to give a fund manger huge chunks of your money each year. But the rules could be set to change.

That’s a bad idea, argues the inimitable Larry Swedroe on CBS:

The performance of hedge funds demonstrates very clearly that they aren’t investment vehicles, but rather compensation schemes designed to transfer assets from the wallets of unsophisticated investors to the wallets of the purveyors.

For the past one, three and five years ending July 2012, the overall HFRX Global Hedge Fund Index produced annualized returns of -5.2 percent, 1 percent and -3.4 percent per year, respectively. […]

For the same one-, three- and five-year periods, the S&P 500 returned 9.1 percent, 14.1 percent and 4.4 percent per year, respectively. And five-year Treasuries returned 4 percent, 6.1 percent and 6 percent per year, respectively.

And for the period 2003-2012, the HFRX index underperformed every single major stock and Treasury bond index, while exposing investors to far more risk.

What the SEC fails to understand is that having significant wealth doesn’t automatically qualify people as sophisticated investors. If it did, the hedge fund world would be a lot smaller.

Are you a well-funded institution seeking convoluted strategies to wring even more diversification from your multi-billion pound portfolio? An Ivy League fund manager, say, who gets the first phone call and discount rates on new funds?

You’re not? Then steer well clear of hedge funds. Or at least please don’t tell me I’m a silly thing for not understanding what I’m missing out on.

I already do my bit for charity. Hedge fund managers can fend for themselves.

From the money blogs

Book of the week: I haven’t read the relatively new Backstage Wall Street by Josh Brown yet, but it comes highly recommended. Half-price as I write.

Mainstream media money

  • Trade in key ETF poised to overtake trade in its companies – Bloomberg
  • Buffett, near 82, reflects on life in Omaha – Associated Press
  • Wooden skyscrapers – The Economist
  • Lessons from my ‘free’ cruise – CBS
  • Now is the perfect time to buy shares – Motley Fool
  • Retail investors know nothing – NY Mag
  • Download FSA’s new guide to RDR changes – FSA
  • 10 dangerous things you learn in business school – Forbes
  • Lump sum cash savers should seek bonuses – FT
  • Warnings over corporate bond funds [Cool data graphic]FT
  • FTSE 100 is five times more volatile than in 1990s – Telegraph
  • Ultra-cheap HSBC first-time buyer fixed rate mortgage – The Guardian
  • Why US companies may be set to payout cash en masseSmart Money
  • [A really dumb article comparing Apple and Facebook shares] – WSJ

Product of the week: NS&I has changed a few terms in its to-die-for index-linked certificates. Does it imply a new issue may be on the way someday?

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{ 9 comments… add one }
  • 1 RetirementInvestingToday September 1, 2012, 10:26 am

    Hi TI

    The following logic is why I will always stay away from Hedge Funds:
    1. IMO the more of them there are, the more likely the average return offered by them will approach the average of the market.
    2. What chance do I have of picking one that will then over the long term out perform the market? I’ve proven that I can’t market time so I’d say that I have just as much chance of buying an under performer as an over performer.
    3. Therefore because of 2. I’ll buy a few of them to minimise risk which when combined with 1. ensures I am likely to get the market average return.
    2. Now the kicker. If you own funds with the 2/20 structure, as you point out in the article, then I am now guaranteed a return below the market.

    Based on that logic (IMHO of course) I’m backing my simple no nonsense strategy of trackers (with a few direct holdings), flexed a bit by mechanical tactical allocation over the long term. Why? Not because I’m clever but simply because I’m relentlessly minimising expenses and taxes.

    Of course only time will tell.

    Cheers for the top read
    RIT

  • 2 David Stuart September 2, 2012, 11:59 am

    Those hedge fund stats against S&P are stunning

    Maybe some very wealthy clients go to hedge funds to protect there investments/even that isn’t working.

    Brilliant write-up Investor

  • 3 Ethan's Money September 2, 2012, 6:53 pm

    I would never invest in a hedge fund because it violates my rule that I won’t put money into something that I don’t, at least broadly, understand.

    I’m also a fan of passive investment. Unless you have significant time to devote to researching your investments, you are likely to get beaten by the full-time market professionals. And active investment ups your hurdle rate because you need to cover transaction costs and fees.

    I’m also have a very, very low tolerance of fees, and will spend a lot of time trying to understand the TER before putting money into an investment. I sometimes worry that I put excessive emphasis on fee structure and miss out on strong-performing but expensive funds, but to an extent it’s a matter of personal principle.

    I can’t imagine that I would ever knowingly sign up to a 2/20 fee structure (2% management fee on total assets invested and 20% fee on any profits earned above a pre-determined threshold) – the structure is asymmetrical, so you don’t get a fee claw-back if the fund underperforms by 20%. Just wrong.

    Cheers – the article was a great read.

  • 4 Ethan's Money September 2, 2012, 7:04 pm

    Oh, and thanks for the link to Money Moves Markets. The blog wasn’t previously on my radar so it’s a great find.

    With respect to their current article, German money supply might look fine but M1 still looks sickly in the periphery. Scary. I had some small investments in European equity funds and have sold these in view of currency devaluation risk. I’d definitely avoid Italian and Spanish equities at the current time.

    Having just come back from holiday the Canary Islands, I can confirm that the Spanish residential property market is on its knees as well.

  • 5 Luke September 3, 2012, 10:03 am

    @Ethan’s Money – thanks for the 2/20 explanation, I wasn’t familiar with that one before now

  • 6 ermine September 3, 2012, 9:11 pm

    Not much to do with the subject at hand, but I was tickled to learn that those Quaker Guns worked some of the time, leastways as far as winning the battle, it seems 😉

  • 7 The Investor September 3, 2012, 11:24 pm

    @ermine — Indeed! The hedge funds smoke and mirrors works quite well a lot of the time, too… For the hedgies! 😉

  • 8 EMH September 4, 2012, 12:25 am

    Hi, the only thing that I think you can say in their favour is that they are uncorrelated with the main market. Your reply that they work…’for the hedgies!’ seems spot on!

  • 9 The Investor September 4, 2012, 11:47 am

    @Ethan — I actually increased my European tracker holdings a couple of months ago, and recently bought a small amount (1% of total portfolio) of Banco Santander. Everything was smashed to smithereens, valuation-wise. I think the P/E of the Spanish market when I tilted was something like 6. Oh well, different views are what makes a market, and it won’t look so clever if the ECB doesn’t push on with its promising talk. 🙂

    @EMH — I think that’s still true for some of the strategies, but it’s been less and less true for years. Prior to the credit crisis many hedge funds amounted to leveraged directional punts. See this table for more correlation data:

    http://monevator.com/think-youve-spread-your-risk-think-again/

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