Hedge Fund Performance

Veblen: author of The Theory of the Leisure Class

Yesterday's buzz on CNBC centered on hedge fund performance and the article Panic in Hedge Fund Land by Lee Brodie that reported that only 11% of the hedge funds tracked by BarclayHedge outperformed the S&P 500.  Hedge funds are available to "sophisticated investors" at a hefty fee.  They are managed by the "Masters of the Universe" of the investment world.

The unsophisticated seek to be sophisticated.  This is a fact of economic life and is just a variation of Veblen's observations on conspicuous consumption.  This is an area where you don't want to be sophisticated.  Stick with the proven low-cost, well-diversified index funds.

Here's some insight into this corner of the investment world:  The 10 Greatest Hedge Fund Implosions of All Time by Thorton McEnery.

What is a Long/Short Fund?

I think it was President Reagan who popularized the phrase "Here we go again!"  After a brief respite, Main Street is once again trying to fathom the workings of Wall Street.  $2 billion lost hedging....but hedging is supposed to reduce risk, right?  More head scratching ensues as Dimon explains an "egregious mistake."

Part of the disconnect is in the word "hedging."  To Wall Street, taking $2 billion to the race track and putting it on a long shot is hedging.  I don't think Main Street quite looks at it this way.

I was introduced to hedge funds at a luncheon in a hoity toity Washington D.C. restaurant by a Dean Witter institutional broker more years ago than I want to remember.  He explained he had a manager using a long/short approach.  The manager analyzed the stocks in the S&P 500 by screening on cash flow metrics, P/E ratios, earnings growth rates - all the usual stuff.  This identified the 50 stocks most undervalued and the 50 stocks most overvalued.  With these in hand, the manager shorted the worst 50 (sold them even though he didn't own them) and with the proceeds bought the best 50.

The broker explained this produced the holy grail - no matter which way the market moved the long/short fund would produce a positive return.  Wow...give me the dessert menu.

I was at a presentation this past Saturday where various investment strategies were enumerated.  A phrase that kept popping up was "it works until it doesn't."  This comes to mind with the long/short hedge funds.  When you think about i,t there is no long/short hedge except in the mind of the broker and the manager.  What happens when the 50 stocks shorted outperform the 50 best stocks?  Oops! This is sort of an embarrassing question because it implies the fund manager might not be that astute.

I was presented with many synthetic derivative proposals by Bear Stearns in the mid 1990s.  I frankly didn't come close to understanding most of them.  I did understand that they were the most illiquid impossible-to-price instruments I had ever come across.  As I read about JP Morgan London buying a credit default swap index to hedge high-yield global bonds (with the craziness going on in Europe), I  remembered the garbage I used to have presented to me that gave me a headache.

The best part of this for me is watching Maria Bartoromo go apocalyptic on CNBC whenever a guest suggests that maybe Wall Street needs to stop this so-called hedging. T he fact of the matter is that banks are no longer banks as most people understand them and instead are gambling casinos.  Sadly this is what did in Freddie Mac and Fannie Mae and has the potential to bring down the banking system.

Buffett Ahead of the Hedge Funds

When I set about convincing non-investment people on the efficacy of low-cost indexed investing, I usually face a challenge.  Many of them have had a bad experience with their investments.  That's why they are talking to me.

I am up against the suits and the resources of well-heeled firms that have honed their sales pitches to the nth degree.  I'm against the hard thought-out processes of cleverly hiding fees and poor performance.  I'm against the presenters of carefully selected funds that have outperformed in the past.

It is easy for me to empathize with the 3rd runner up in some of today's presidential primaries.

But I bring heavy hitters to the plate.  These include Burton Malkiel, Dan Solin, John Bogel, Andrew Hallam, Jack Meyer, and many others.  The most powerful, though, is Warren Buffett who states that professionals even should follow the low-cost index approach.

Warren Buffett says:

Most investors, both institutional and individual, will find the best way to own common stocks is through an index fund that charges minimal fees.  Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.

All of this, of course, is more than an academic exercise.  Many of the above mentioned people spent lifetimes studying and analyzing data on market performance before they arrived at their conclusion. Warren Buffett went a step further.

The Bet

On Jan. 1, 2008, Warren Buffett bet Protégé Partners LLC, a New York fund of hedge funds co-founded by Ted Seides and Jeffrey Tarrant, $1.0 million they couldn't pick an index of five funds that would outperform  the Standard & Poor’s 500 Index over the 10-year period ending Dec. 31, 2017.  These funds are funds of funds.

The fund of funds hedge fund pitch is interesting.  Hedge funds are for the wealthy.  To get in them, you have to put up a lot.  Everybody knows, however, that diversification is important.  Thus, you want your investment dollars to spread among several hedge funds.  Not easy unless you are ultra rich.  Enter the "fund of funds."  Now you are diversified and getting management from the best of the best - at least, that's the pitch.  All of this and you are investing like the ultra rich!  You are ready to head to the neighbor's barbecue and brag that you are invested in hedge funds.

I once listened to a pitch to a group of do-it-yourself investors that presented impressive graphs as part of a power point that showed the exceptional performance of hedge funds over the past 20 years.  I asked if Long Term Capital Management was included in the results.  The presenter didn't know - at least, that's what he said.  Long Term Capital Management was the largest hedge fund in the world - before it went broke.

As of the most recent calculation on the bet, Buffett has a return of 2.2% (using Vanguard's Admiral funds) and the hedge funds are down 4.5%.

Brad Alford, head of Alpha Capital Management LLC in Atlanta, says "hedge funds of funds have underperformed because of high fees and mediocre manager selection."  Interesting.  It seems that with $1.0 million on the line and, even more importantly, pride, that the hedge fund manager made his best picks.

The fees part of it we definitely get.

The details of the bet can be seen at http://longbets.org/ .