Last week, I gave a very informal presentation to an audience of sophisticated HNW investors. Lots of family offices, none with less than $10m net worth; I’d ballpark the median > $50m. They get together regularly to discuss investing issues they are wrestling with.
The presentation was very general, including my (non)outlook on the economy, markets, investing, etc.
During the Q&A portion, issues of asset allocation, indexing, tactical adjustments, rebalancing, behavioral economics, and more were batted about. One of the questions that came up was fund manager under-performance. Starting with the usual data points — 80% of managers miss their benchmark, etc. — we then discussed why family offices, foundations and institutions were so willing to pay 2+20 for what is sub-par performance. Yes, 2011 was a rough year, but the problem seems to go much further than that.
One of the questioners asked, and surprised himself with the answer: “Based on all this, then why do we bother picking hedge funds anyway? Why shouldn’t we simply index?”
Why shouldn’t you, indeed? I replied that I thought indexing made sense for many HNW investors, but I favored a form of tactical overlay versus straight Buy & Hold. (We’ve discussed the 10 month MA as a simple sell signal). We never got to discuss the incentives that drive consultants to sell these folks on the belief that they can consistently select managers who can out-perform; that is worthy of a full discussion some other time.
The most interesting part of the discussion was almost an afterthought. After stating that, yes, there were 100s of very talented hedge fund managers — out of a pool of 10,000 — I asked the group this: How can you find these outstanding hedge fund managers? How can you evaluate whether to give them your capital? How successful have you been at this?
No one had much of an answer.
We know exactly who the superstars are ex post facto. But we don’t get to retroactively go back in time to give our money to Jim Simmons or Ray Dalio. I told the group that I am “awful at selecting managers who don’t have a 10 year track record of out performance; (though I redeem myself by knowing when to fire a manager).”
But the really interesting part came in the form of a challenge to the group: “Who is good at picking Hedge fund managers? Who amongst you has the ability to consistently evaluate managers who then outperform over time? Not only that, but outperform on an after fee basis?”
Their was a stunned silence.
I continued: “I do not have that skill set. Evaluating hedge fund managers based on the information that is currently shared is not my forté; more importantly, I doubt YOU have the skill set to pick hedge fund managers. (if you did, why are you here?)”
I pointed out the simple fact that most of us are not well equipped to evaluate managers. The ability to evaluate someone based on either understanding their approach and temperament was not what most of us were capable at. I continued: “That is what Excel is for; You mark down the quarterly and annual track record managers you select (monthly performance data is mostly noise), keep a list of the qualifications you used to make that decision. Then you track their performance net of fees. How have you done?“
Understand exactly what I am saying: Its not that there aren’t 100s of managers worthy of your capital — there are 100s maybe even 1000s who are. However, you simply are not well equipped to pick them. Sure, we can look at long-term track records. Bridgewater is Institutional only; Renaissance Technologies returned outside investor monies; There are lots of well known funds doing extremely well over a multi-decade plus period — but good luck getting them to take your money at this stage.
Time was up, the moderator thanked everyone, but the question remains: How many investors can consistently select hedge fund managers who beat their benchmark over long periods of time after fees?
2011: Disastrous Year For Mutual, Hedge Fund Managers (January 17th, 2012)
When Do You Fire a Manager? (April 5th, 2011)