It was another great year for investors who avoid hedge funds
For the seventh year running highly paid experts were worse than simple index funds
Amid the tweets and bonfire of expertise last year, did you notice the worldwide boom in asset prices?
For instance, a non-exhaustive list of ways an investor might have increased their wealth by more than a tenth in 2016 includes: crude oil; the major stock market indices for the US, UK, Brazil and Russia; Emerging market equities as a whole; pretty much any high yielding corporate bond market; sugar, silver and copper; even gilts, debt of the UK government.
Yet the premium part of the asset management industry, cosseting its sharpest minds in the most luxurious offices, had another dismal year. The average investor in a hedge fund, according to data provider HFR, saw their money grow a mere 2.5 per cent last year, only slightly more than investors handed over in fees, of roughly $65bn.
The immediate question might be how so many hedge fund managers failed to do better. Places to lose money were scarce in 2016 for anyone who didn’t place a bet on sterling ahead of the UK vote to leap from the EU. Wheat prices, companies reliant on the British economy, and stocks listed in Shanghai top a small list of ways to have substantially reduced wealth.
A bigger question, however, is why the investment performance of hedge funds has been so poor for so long.
It may be because exposing the mediocrity runs into a problem of measurement. There is no perfect way to assess a diverse industry made up of as many as 10,000 funds. Clever investment managers are a cohort, not an asset class.
A portfolio of investments in hedge funds is also a weird concept: we’d like the average ability of a group of people to make investment decisions, chosen for their historic ability to do so even though academic studies show past performance genuinely is no guide to the future, please. Various fee-generating businesses exist by presenting such weirdness as a challenge to be solved by consultants, advisers and banks.
Still, one low bar for measurement is a simple combination of cheap index funds, say $60 in US stocks and $40 in Vanguard’s Total Bond Fund each year: in 2016 it became $108. Indeed, in each of the past seven years the index funds were the better choice than $100 managed by the average hedge fund, weighted by assets and again using HFR numbers.
Expert money managers did have a good financial crisis on this measure, but have been considerably outpaced since. Over the past decade $100 using the dual index fund approach became $184, while the average hedge fund investor would be left with perhaps $159.
The first reason is fees: investors paid at least $34 to hedge funds over the decade, to see their money grow by $59, based on conservative estimates for typical costs and not including the expense of choosing or monitoring the hedge fund managers.
Second is a collapse in interest rates, which has been good for simple bond funds but made life hard for hedge funds, as cash balances they hold while shorting stocks or doing other complex activities no longer offer easy income.
Technology and regulation are also part of the challenge. Information is much more freely available than in the past, and in some ways it is easier to trade. Profitable market niches tend not to last when as many as 10,000 hedge funds with $3tn to invest are all looking for them.
Post-crisis rule changes to restrict trading by investment banks have also, arguably, introduced more random movement to markets. Such temporary swings are a problem due to another group who deserve blame: the pension and sovereign wealth funds who invest in hedge funds.
These so-called institutional investors tend to prefer large and respectable looking hedge funds, and can be alarmed by paper losses which are taken as a signal of poor risk management. The result is hedge funds focused on not doing anything stupid which might cause the big investors to take their money away.
An overabundance of caution does not lend itself to reliable investment growth. Instead, collect management fees, talk darkly about future crisis and hope investors do not notice how well they could have done without you.