Hedge funds should go back to hedging and also consider lower fees.
Equity hedge funds are under tremendous pressure, having underperformed their benchmark in nearly every year since 2008. But can it really be true that the average equity hedge fund is no better over the long run than granny’s passive indexed ETF or mutual fund that tracks the S&P 500?
On one side, hedge funds employ full-time cohorts of smart ambitious highly credentialed people who spend long hours and a lot of money visiting and analyzing companies to find the best opportunities. They sit in beautiful new offices and use the latest in real-time data feeds and state of the art technologies.
On the other side, granny alone on her springy sofa in a drafty den peers at her indexed investment once a quarter and makes changes at most once a year, if at all, by calling an 800 number on an 1980s telephone. It seems implausible that she is outperforming with so little effort a large majority of hedge funds.
Yet, this is the argument that Warren Buffett has made once again during Berkshire Hathaway’s annual shareholder meeting. Buffett has a running bet with hedge fund firm Protégé Partners that the S&P 500 index will outperform their selection of hedge funds over ten years starting on January 1, 2008.
Several people posted this table on Twitter comparing the performances of the index and of Protégé’s hedge fund selection.
The obvious immediate takeaway is that after eight years, the index is killing the hedge fund basket turning $100 invested into $165.7 vs. only $121.9 (Note: the annual numbers shown actually add up to $120 cumulative for the hedge fund).
Another takeaway is that the index was not always leading. In the first four years starting in 2008, the hedge fund basket was beating the index. Annual cumulative figures are shown below. In yellow are the years when each was leading.
Most alarming is the fact that the hedge fund basket lost 23.9% in 2008. The very name ‘hedge fund’ means that it should be hedged and that therefore it would not lose much money in a bear market. Once upon a time, that was the whole point of a hedge fund. It was intended to make money in bull or bear markets, or at least to not lose money in bear markets, or at least to not lose a lot of money in bear markets.
So let us run two scenarios and say for the sake of comparison that Protégé’s hedge fund had been effectively hedged and that it had lost no money in 2008. Let us further stipulate that because it was always hedged, it only managed to record half of the gains of the index in all other years. Here are the results. We see that under this scenario, the hedge fund basket would have beaten the index while experiencing much less volatility.
This is a bit of an extreme example however because 2008 was a very very bad year for the S&P 500. So say instead that in 2008, the S&P 500 had declined 20% instead of 37%. How well would the hedge fund need to perform in the other years in order to match or beat the index in the ten year period?
The answer is that the hedge fund would have had not only to preserve capital in 2008 (in other words, not lose money), but to also log three quarters of the index’s gains in the other years (vs. one half in the last scenario) in order to keep up with the index. This is shown here below:
Both of these scenarios are difficult to implement however. In the first case, it would be difficult, though not impossible, to completely avoid losses in a year when the market loses 37%. And in the second case, it would be difficult, though not impossible, to record gains equivalent to 75% of market gains while running a hedged fund. Remember that these are after-fees figures which means that before fees, the hedge fund would have to match market gains despite the fact that it is hedged. Both of these scenarios are plausible but both would require investment teams that are well above average.
As an aside, It remains to be seen whether the same fund manager (or team) can produce strong results in a bull market and also lose absolutely no money in a 20%+ decline. Many hedge funds encourage an internal culture and reward system that make it difficult to achieve both outcomes. In her best-selling book Quiet: the Power of Introverts in a World that Can’t Stop Talking, the author Susan Cain writes that Wall Street became the victim of its own success in 2008 after years of promoting and rewarding bullish risk-insensitive ‘extroverts’ while setting aside risk-aware ‘introverts’ who were in theory more capable of preserving capital in crisis situations. When the crash approached in 2007 and finally struck in 2008, most financial institutions had already adopted a monoculture of unbridled risk-taking and were as a result completely unprepared to avert huge losses.
The two scenarios in the tables above distill the two problems afflicting the hedge fund model: lack of hedging and high fees.
Lack of Hedging
A big problem with hedge fund performance is that most hedge funds are no longer hedged. There are very good reasons for this:
- Hedge fund managers are paid performance fees that are calculated from annual gains. The typical performance fee is 20% of realized and unrealized gains. This creates an incentive for managers to forgo hedging in order to maximize gains in positive years. By contrast, preserving capital during difficult years may generate good publicity and create goodwill among investors but it is not directly rewarded through compensation. Managers who hedge aggressively tend to make less money for themselves and their teams than managers with an unequivocal bullish disposition.
- Hedging and shorting are difficult skills that require good macro timing. Few managers have mastered these skills and few are capable as a result of avoiding losses in years like 2008 or even in less extreme years when the market is down 15-20%.
- Investors increasingly expect hedge funds to keep pace with or outperform the S&P 500 index in positive years. A fund that delivers half the returns of the index, as per our example above, will not retain investors for long, even if it outperforms the index in the long run. This tends to be the case because competition for assets is fierce, promises are overly optimistic, expectations are high and memories are short. The long run usually does not come soon enough to save a fund from withdrawals by impatient investors.
- Allocators to hedge funds are typically not the owners of the capital being invested, but agents (funds of funds, pension funds, endowment managers, private bankers etc.) investing on behalf of someone else. They too have an incentive to record big performance years and derive little comparable benefit from preserving capital in a bear market. Although they run the risk of being dismissed in down years, few were let go in 2008 when nearly everyone else also lost money.
There is a large asymmetry therefore between on one side the fees and positive publicity a hedge fund manager extracts in strong years and on the other side the lack of reward in years when capital is merely preserved. Compounding this quandary, few investors are willing to stay with a fund while it underperforms year after year just on the expectation that it will preserve capital in a downturn. The pressure to win every year is simply too great.
The asymmetry is exacerbated by the fact that fees paid in profitable year x are not returned or clawed back by investors in losing year x+1. This means that a manager can be up 33% one year and down 25% the next year and walk away with substantial fees even though his fund is flat on the two years. This too encourages a manager to be bullish and to avoid hedging.
The issue of hedging therefore is intertwined with the issue of fees. Typical hedge fund fees are 1) a management fee equal to 1 to 2% of assets under management (AUM) and 2) a performance or incentive fee equal to 20% of a fund’s gains in a given year.
Performance fees are paid on both realized and unrealized gains, a feature that is unique to hedge funds. If a manager buys a stock that doubles by December 31st, he will derive a fee from this trade even if he is still holding the stock into the new year and it falls 50% in early January.
Generally speaking, hedge fund fees are so generous to the manager and his team that they depress the fund’s performance after fees and make it very difficult for a fund to outperform an index over several years. It is difficult enough, as many mutual fund managers will attest, for a low-fee active fund to outperform the index. High fees make it practically certain that a large majority of hedge funds will underperform over a prolonged period.
When comparing to an indexed fund, taxes should also be considered. If you are a US-based tax-paying investor, you will pay a capital gains tax every year on every profitable position sold by the hedge fund. By contrast, if you invest in an indexed fund, you will only pay capital gains taxes when you sell out of the fund which may be years or decades after you buy in. Buffett’s comparison of an index and a hedge fund is even more damning to the hedge fund if we look at after-tax returns.
Having said that, most hedge fund investors are exempt of US taxes because they are foreign entities or tax-exempt US-based pension or endowment funds. It is a strange reality that a non-US citizen living in a low-tax foreign country can invest in the US stock market more profitably, on an after-tax basis, than an American citizen.
The main question then is: would it be possible to engineer a better equity hedge fund, one where performance and fees make sense when measured in the long run against a passive indexed fund? The answer is yes if a hedge fund has a strong team and patient investors, remains hedged at all times and offers lower fees.
There are many outstanding hedge fund managers but the absence of hedging and the high fees make it difficult for hedge funds on average to outperform the benchmark. Although there are outliers who perform strongly year after year, it has become nearly impossible to identify them before the fact out of thousands of existing funds.
Read the second installment: The Way Forward for Hedge Funds – 2