Wednesday, January 9, 2013

Hedge Funds Are Unable to Beat the Market: Why?

Traditional advice to conservative investors has been to put 60% of resources into equities and 40% into bonds. Institutional investors such as pension plans and college endowments have tended to drift into riskier forms of investment in recent years as the outlook for equities has not met their need for high returns. As a result, they have invested heavily in more risky arenas such as hedge funds, private equity, and real estate. This trend should be troubling to those who have a dependence on the health of these institutional investments. An article in The Economist, Hedge funds: Going nowhere fast, provides some insight into the efficacy of utilizing hedge funds to attain those large returns.

This comparison of the performance of an index of hedge funds versus a 60%/40% split on indices representing equities and bonds illustrates that hard times have befallen a once glamorous investment vehicle.

"The past year has been another mediocre one for hedge funds. The HFRX, a widely used measure of industry returns, is up by just 3%, compared with an 18% rise in the S&P 500 share index. Although it might be possible to shrug off one year’s underperformance, the hedgies’ problems run much deeper."

"The S&P 500 has now outperformed its hedge-fund rival for ten straight years, with the exception of 2008 when both fell sharply. A simple-minded investment portfolio—60% of it in shares and the rest in sovereign bonds—has delivered returns of more than 90% over the past decade, compared with a meagre 17% after fees for hedge funds...."

Investors pay a heavy price for relatively poor performance.

"....fees of 2% of assets and 20% of profits (above a certain level) typically charged by hedge funds...."

The knife is then turned with this observation.

"As a group, the supposed sorcerers of the financial world have returned less than inflation. Gallingly, the profits passed on to their investors are almost certainly lower than the fees creamed off by the managers themselves."

There continue to be high performing funds, but they are not always the same ones. Big winners of a few years ago have become big losers of today. The author suggests there are a number of changes that have occurred that have altered the environment in which the hedge funds now operate.

The funds may have been damaged by their earlier success. As they have grown in size they have found that it was easier to be nimble and quick when small rather than after becoming big and bloated. The nature of their investors has also changed. Whereas they were once the province of risk-seeking wealthy individuals, now about two-thirds of their funds come from institutional investors whose goals are much less adventuresome. In the past, funds were able multiply their returns by leveraging their assets with borrowed funds. That option has mostly disappeared.

The author then provides what might be the most compelling, and the most intriguing explanation—one that should be relevant to all investors.

"[ Hedge funds] attribute their woes to choppy markets that are moved more by politicians than by underlying economic forces. ‘Markets are watching governments, which are watching the markets,’ says Jim Vos of Aksia, a consultancy. Even a talented stockpicker will struggle to make money if the entire market is sent into convulsions by central-bank announcements. Many hedgies admit to having no ‘edge’ in this environment. A few have slimmed or shut up shop."

The funds now seem to be propagating a message of diminished expectations.

"For those that remain, the message to investors has changed dramatically. Whereas hedge funds used to sell themselves as the spicy, market-beating wedge of an investment portfolio, they now stress the long-term stability of their returns."

One of the products of our poisoned political environment is a poisoned investment environment. However, this uncertain state has tilted the focus toward more stable long-term investment options. Less gambling and a greater focus on financial fundamentals—can that be a bad thing?

But where are those institutional investors to go now? Will they seek even riskier investments?

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