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Author: chris dillow   |   Latest post: Fri, 5 Mar 2021, 12:07 PM

 

Hedge fund humbugs

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At the end of the Wizard of Oz the wizard is revealed not to be somebody of superhuman powers but "just a common man", "a humbug". Hedge fund managers are like that. Whereas their enemies, such as some of the posters on Wall Street Bets and indeed many on the left generally, sometimes pretend that they are evil geniuses the truth is much more mundane.

Data from Hedge Fund Research tell us this. They show that the average hedge fund has made 5.6% a year in the last five years. That might sound OK. But you could have made twice as much by just leaving your money in a fund that tracks MSCI's world index; over 10 per cent in gold; and 3.8% in US Treasuries. Which means reasonably balanced funds which any investor could create for themselves have done as well as the hedge fund; in recent years any fool could have been a decent asset allocator. Wiz

The average equity market neutral fund - the sort that takes short positions in stocks - has done worse than this, making less than 2% in this time.

Of course, some funds have done much better - but then, somebody wins the lottery every week - but others have done worse. Crispin Odey's Odyssey fund, one of the UK's higher-profile funds, has lost almost 50% since 2016.

Hedge funds, though, aren't the only mediocre funds. Conventional equity unit trusts also do badly. The Financial Conduct Authority says these "did not outperform their own benchmarks after fees." And David Blake and colleagues have concluded that (pdf):

Almost all active fund managers fail to outperform the market once fees are extracted from returns.

Hedge fund managers, like their conventional counterparts, are not great wizards.

If you believe the efficient market hypothesis - which says that all information is in the price and that you therefore cannot beat the market except by taking extra risk - this is just what you'd expect.

But there's a puzzle here. As I've said for ages in my day job, there are two (and perhaps only two) well-attested ways to beat the market - by investing in defensive (pdf) stocks or simply in ones that have risen in recent months. We'd expect many funds to do well simply by adopting these strategies.

And yet they don't. Why not?

Many do try to exploit momentum: several of the most shorted stocks in the UK are long-term munters such as Cineworld, Premier Oil or Metrobank. But it's dangerous to short even bad stocks because their prices can jump quickly: in the first two weeks of November, for example, Cineworld's price jumped 50%. Such jumps require shorters to put up more cash - the margin call, which, says Dan Davies, is "one of the most frightening things in the financial world." Shorting is much easier in theory than in practice - which is one reason why markets are not fully efficient.

This, however, just raises the question: if hedge fund managers are duffers, why are they rich?

It's because they are clever not at asset management but at asset gathering. They make their money from fees: why do you think they go to the hassle of dealing with clients rather than simply trading at home on their own account? Hedge funds typically raise money from other institutional investors who are managing it on behalf of you and me. And as Milton Friedman
pointed out years ago, when people spend other people's money on other people, "they don't economize and they don't seek the highest value".

Many also benefit from a tax break: their fees are taxed at an anomalously low rate.

My point here is more about politics than finance. Our class enemy are not evil geniuses practising some arcane magic; investing successfully requires little intellect. Instead, they are beneficiaries of emergent processes such as principal-agent failures and deference towards the rich and of the cronyism that gives them special treatment from the state. There are no wizards, just common little humbugs.

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