Here is Dave Leonhardt’s stimulating piece. Here is the key fact:
Last year, the Standard & Poor’s 500-stock index jumped 14 percent, while the average hedge fund returned less than 13 percent, after investment fees, according to Hedge Fund Research in Chicago…Since 2000, the average hedge fund hasn’t done any better, after fees, than the market as a whole, according to research by David A. Hsieh, a finance professor at Duke.
My guess is that a small number of very bright individuals can in fact beat the market on a systematic basis. Today the world can mobilize enough capital so that these people become very very rich and have a larger impact on market prices than in times past. These individuals also spawn overconfident imitators, which lead to subnormal returns for the non-superstars. On average the gains and losses are a wash, but the true stars must limit the amount of capital they manage, for fear of pushing around market prices too much. Some set of insiders thus continue to gain wealth whereas most outsiders are playing the usual efficient markets game, with slightly subpar returns, due to the informed trading of the insiders. The geniuses are in effect taxing the uninformed trading of the non-genuises, but I do not see the trading volume of the latter group falling in response. In that model, in the first best, it is the trading of the losers — not the winners — which should be taxed.
Note that the winners get people interested. Since they cannot buy the winners they “buy the segment”, i.e., anyone calling themselves hedge funds. Many of them are former mutual fund people doing the same thing for far bigger commissions. Irrational investors, yet again. (They will probably sell low when demand for hedge-funds crashes
What makes you think that anyone can consistently beat the market, other than through luck?
It’s not a misleading comparison. Investing in a no-load S&P 500 index fund is (or should be) the default option of anyone wishing to commit capital to the public markets.
Guys like Ken Griffin and Louis Bacon seem to have what it takes to beat stellar returns year in and out, but they are quite likely to be exceptions to the rule.
The risk issue is key here. If you simply leverage up financial asset returns you will have higher returns during bull markets, but you will have taken more risk. The return/risk ratio will be constant. A lot of institutional investors will pay for the ability to access leverage alone. The average hedge fund has a correlation with the SP500 of about 60%.
Even if you are creating current returns through other trading strategies besides simple leverage, the amount of risk being taken is not always transparent in the short run. Writing options [or the equivalent] and collecting premiums is one way to hide implicit risk, while measured risk remains low.
Finally, large hedge funds have the ability to create trends in the market, and capitalize on others chasing these trends, especially less sophisticated individual electronic day traders. This is one manifestation of what Tyler is getting at I think.
I can believe the average fund has generate a return equal to the S&P500…but that is *after* fees, and with less volatility, so that suggests more hedge fund growth.
There are three things one has to look at allocating money to different investment choices: return, risk and correlation to current portfolio (which is related to the risk piece).
Looking at returns alone can be highly misleading. For example on a pure returns basis I could have “beaten” the S&P last year by simply borrowing some money and investing along with my own money in the S&P. I would have taken a lot more risk (as measured by standard deviation of returns). Conversly, I would have lost my shirt if the market went down last year instead of up.
So you have to incorporate risk. All things equal you want a manager who gives you more return for each unit of risk that you take. With one exception…correlation.
I can easily show many cases where I would rather include a manager who has much worse return per unit of risk than the S&P but you might still invest with that manager if her correlation to your portfolio is lower than the S&P.
If you are someone like me who invests in Vanguard index funds your portfolio is highly correlated to the market. The appeal of hedge fund is that they claim to be market neutral (i.e. 0 correlation to the market and my portfolio).
If they can reliably do that, then I would want to allocate my marginal dollar to them despite lower returns and even in the case of lower returns to risk rate (technically it should be excess returns over the t-bill rate to risk ratio).
At the end of the day I think a lot of hedge funds (in fact the vast majority) are not market neutral. We just havent seen a down market in a few years…
I think part of the reason for the debate here is that “hedge funds” have no clear definition. Just about any unregulated investment fund can be called a hedge fund even if it does not engage in actual hedging. Tyler is talking about that class of funds run by people who made $1 billion in income last year and that charge 20% of the upside. These are clearly designed to convince people they can earn supernormal returns (and beat all of those suburb-dwelling, middle-class mutual fundies).
In that model, in the first best, it is the trading of the losers — not the winners — which should be taxed.
And they are — in the form of higher transactions costs.
I couldn’t agree more with the world view expressed in this post. This is almost exactly how I view the capital markets.
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