The Amazing Disconnect Between Hedge Fund Performance & AUM

Earlier this week, Greg Zuckerman of the Wall Street Journal pointed out one of the great mysteries of today’s investment landscape: Despite underperforming by a substantial margin, hedge funds keep attracting more investors and assets under management. It is almost as if (to borrow the headline on Zuckerman’s article), “Hedge Funds Keep Winning Despite Losing.”  He wrote:

Hedge funds aren’t just underperforming against the S&P 500 and other stock indexes. They’re also losing out to low-cost “balanced” mutual funds that hold a mix of stocks and more-conservative investments, just like many hedge funds, suggesting their poor performance can’t be blamed on a hedged approach.

Consider the data: According to HFR, a firm that created indexes to track hedge-fund performance, the average hedge fund gained a mere 3 percent in 2014 versus an 11 percent rise in the Standard & Poor’s 500 Index. That’s hardly worth paying a hedge fund outsized 2 percent management fees plus a 20 percent cut of the profits.

Simon Lack, in his book “Hedge Fund Mirage,” describes why indexes such as those developed by HFR significantly overstate returns. That 3 percent gain last year, or about 7 percent annually since 2009, likely excludes funds that underperform. Funds don’t have any obligation to report their performance — it’s strictly voluntary. What we see in these indexes is an absence of poor performers that, were they included, might give a more accurate picture of the industry’s results. And that’s before we get to the issue of survivorship bias — funds that have gone belly up and closed due to their dismal results are missing from the index as well.

Perhaps you believe that the S&P 500 is an inappropriate benchmark. Consider a simple 60/40 portfolio of stocks and bonds. According to research from the Vanguard Group, that simple portfolio beat the returns of not only the hedge-fund industry as a whole, but almost all of the individual funds except for the outlying performance stars. And this 60/40 portfolio did it while charging fees of just 0.24 percent. The balanced fund beat the main Bloomberg hedge-fund index in six of the last seven calendar years, according to data compiled byBloomberg. No wonder there is so much angst in Greenwich, Connecticut, home to many hedge funds. See the following chart comparing the S&P 500 and the Bloomberg Global Aggregate Hedge Fund Index since January 2010:

SPX Index (S&P 500 Index)  Daily 2015-02-12 08-52-43

Now comes finance’s most fascinating paradox: Despite the underperformance and high fees, hedge funds now have $2.85 trillion in assets under management. That is a 78 percent gain from the $1.6 trillion in 2009.

We have delved deeply into the issue of why hedge funds underperform, the dilemma that allocators face when choosing hedge-fund managers, and why, despite all of this, “Investors Still Love Hedge Funds.”

The best answer I can come up with is that investors are irrational. Hardly a groundbreaking insight, I know, but it is the best explanation I’ve been able to reach.

People who have thought about this question long and hard offer two other possible explanations. The first is the concept of inflated expected returns, while the second is the principal-agent problem.

I have yet to figure out a rational basis for the inflated expected return assumptions that endowments and public-pension funds use when making their alternative investments. The best, albeit most nefarious, reason that states use inflated expected returns is that it reduces the amount the state must contribute in any given year to their pension funds. That lowers the amount they need to tax their citizens to meet their legal obligations. When given a choice between embracing an obvious lie told to them by their state treasurers or investment committees, or raising taxes, most politicians are all too happy to embrace the lie.

That leads us to the principal-agent problem. The industry consists of fund managers (agent) who are empowered to act on behalf of another party, their investors (principal); but many of these agents don’t have a true legal fiduciary obligation to act in the best interests of the principal. Ostensibly motivated to perform on behalf of their employers, but not legally under that obligation, it’s not too difficult to figure out what happens next.

This is of a piece with the “amazing disconnect” that Simon Lack described to John Cassidy last year in an article in New Yorkermagazine. Lack observed: “The entire hedge fund industry is designed to channel assets into hedge funds. Everyone – consultants, advisers, funds of funds, capital introduction groups of prime brokers – recommends investing in hedge funds. Nobody is providing the opposite view.”

Based on those capital flows, that amazing disconnect is alive, well and growing.


Originally Published here


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  1. rd commented on Feb 12

    It’s all the Fed’s fault. hat is the basic conclusion of why hedge funds are underperforming the S&P 500 in the Warren Buffet vs. Ted Seides

    BTW, 7 years into the bet, Ted Seides is realizing that comparing hedge funds to the S&P 500 isn’t appropriate. My question: Why didn’t he know that 7 years ago? He could have reset the terms with Warren Buffet to some rebalanced worldwide basket of index funds etc. Warren might still have taken him up on that bet.

    As far as I can tell, Ray Dalio runs a quintessential hedge fund where he is not looking to shoot thel lights out in the equity markets. Instead, he is looking to consistently make good money while hedging risks to smooth volatility. He may or may not beat the S&P 500 over an extended period of time, but he would be really disappointed if he had anything like the volatility of the S&P 500.

    Folks like John Paulson appear to be running “hedge funds” that are actually alternative investment trading vehicles with little real hedging going on. He won really big on mortgage backed securities, but has lost big on gold and some other things since then. It looks like the volatility of many of his funds could rival the S&P 500.

    • farmera1 commented on Feb 12

      I was just going to post this link. You gotta love the conclusion by Ted Seides as to why the hedge fund composite is loosing out to Buffett. It is the FEDs fault. It probably has very little to do with the 2 and 20 boys taking the fat off the top, no siree.

      “A number of cyclical headwinds have hindered hedge fund returns, particularly over the last six years. When put under a microscope, hedge funds look a little better than they appear on the surface.”

      But going into the bet Buffett knew what was going to happen, you can’t take 2 and 20 off the top and win. Hence his million dollar bet that a simple index fund would beat any hedge fund or group of hedge funds over a ten year period.

      Here’s what Buffett had to say going into the bet:

      “Costs skyrocket when large annual fees, large performance fees, and active trading costs are all added to the active investor’s equation. Funds of hedge funds accentuate this cost problem because their fees are superimposed on the large fees charged by the hedge funds in which the funds of funds are invested.

      A number of smart people are involved in running hedge funds. But to a great extent their efforts are self-neutralizing, and their IQ will not overcome the costs they impose on investors. Investors, on average and over time, will do better with a low-cost index fund than with a group of funds of funds.”

      As is always the case Buffett was and is right. Disregard Buffett at your own loss.

  2. VennData commented on Feb 12

    The salesmen… er… a… Hedge fund Genuses who are losing their bet to Obama-lover Warren Bufftet have come up with their reasons!

    “…What follows is an assessment of what happened, and an outlook on where to go from here. A number of cyclical headwinds have hindered hedge fund returns, particularly over the last six years. When put under a microscope, hedge funds look a little better than they appear on the surface…”

    ROFL! That’s the whole point. You cannot predict the future. You can’t know. In an infinite number of universes you would beat Hillary-Clinton worshiping Warren Buffett some small percent of the time. Very small.

    • VennData commented on Feb 12

      And oh irony of ironies, here’s why!

      “…We believe that those extrapolating from the recent past to call for the demise of the hedge fund industry are probably a bit extreme…”

      Innumeracy is an ugly thing. Does he have ANY idea how Funny this is?!

  3. DeDude commented on Feb 12

    The personal bribing of endowment and pension fund managers with lavish gifts and perks from the hedge funds need to be investigated.

  4. GeorgeBurnsWasRight commented on Feb 12

    Reportedly a lot of high net worth individuals are very bearish on the market (for what appear to me to be political/cultural reasons.) I wouldn’t be surprised to find out many of these folks are putting their money into hedge funds which promise they’ll protect their clients from big market declines.

    • RW commented on Feb 12

      “A fool and his money are soon parted” and many high-net worth individuals are fools.

      A surprising number of them are stupid too.

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