Sat 6-2-18 Love the Player, Hate the Game - The Big Picture
Hedge Funds Bear the Blame for Looking Bad
They compared themselves to
the S&P 500, then complained when they underperformed.
By
Barry Ritholtz
June 1, 2018, 2:12 PM EDT
A couple of weeks ago, Barron’s interviewed
mutual fund legend Jack Bogle, the inventor of the index fund and founder of
Vanguard Group. One intriguing exchangecaught my eye:
Barrons: “Favorite hedge
fund?”
Bogle: “Reluctantly ...
anything run by Cliff Asness”
As some regular readers may have noticed, I
engage in this little balancing act: I am critical of the hedge fund industry while also
admiring many of its leading managers.
This
isn’t a contradiction. The alternate-investments industry is rife with
problems, many of them rooted in the costs relative to performance. Yet it is
also populated with smart and insightful folks who have expanded our
understanding of complex investing issues. We understand more about risk and
the elements that drive markets today than we otherwise would have without the
incisive research and commentary published by these managers.
One such source of analysis is Cliff Asness,
founder and chairman of AQR. I confess to being consistently
delighted 1 by Asness, despite
occasionally being on the receiving end of his criticism. Unlike many who are endowed with
superior math skills, he is both articulate and
funny.
Obligatory genuflection out of the way, I want
to take a closer look at his recent online commentary, “The Hedgie in Winter.”
Partly because I disagree with some of it, and partly because he makes an
example of me, today I shall defend my critique against his.
Asness writes:
Analysts
and authors often compare hedge fund returns to 100% equities (most often, the
S&P 500). Then, almost always based on the last nine years since the global
financial crisis (GFC) lows, they declare hedge funds an epic disaster. That’s
just flat-out wrong. Comparing hedge funds to 100% equities would be a bad
comparison at any time. To make things worse, this comparison is done over a
cherry-picked time period.
Cherry picking is never a good thing, and
using the wrong benchmark is similarly frowned upon. Examine any list of
disparate and exotic strategies – long only, short bias, global macro, special
situations, distressed debt (see this for a complete
list of hedge-fund investing strategies) and you can see why finding an
appropriate benchmark has been called a “chronic difficulty.” 2 Using
broad, U.S.-based large cap indexes such as the Standard & Poor’s 500 Index
as the benchmark simply makes little sense for many funds.
However, if we are to lay blame on anyone for
that benchmark, the fault lies not with the analysts or news media (or me for
that matter), but with the funds themselves. Historically, they have compared
their performance to the S&P 500 and other large cap indexes. I want to
repeat: It wasn’t the critics of hedge funds that did this; it was
the fund managers themselves that made these claims. Once
the industry’s assertions of outperformance versus broad markets became part of
the sales pitch, it shouldn’t come as a surprise that others used the
S&P500 as the benchmark of choice.
Asness is a notable exception to this
marketing approach. 3 He
believes hedge funds should actually hedge, and
thus should underperform big cap equities during a broadly rising market like
the one we’ve had for much of the past decade. The tradeoff is that they
should outperform once the bull market fades.
As to the cherry-picked timelines, allow me to
suggest two broad analyses that are not cherry-picked, but reach similarly
dismal conclusions. In early 2017, my colleague Ben Carlson looked at hedge-fund performance across
three distinct eras: 1998-2016, 1998-2003 (sometimes referred to as the golden
age of hedge funds) and 2004-2016 against a simple investment portfolio made up of 60 percent
equities and 40 percent bonds. Carlson found that the bulk of outperformance
came “during the glorious five-year period spanning the lead up to and
aftermath of the tech bubble,” in other words, from 1998 to 2003. Since then,
there has been dramatic hedge-fund underperformance.
Simon Lack, in his 2012 book, the “Hedge Fund Mirage,” is
even harsher: “if all the money that's ever been invested in hedge funds had
been in Treasury bills, the results would have been twice as good.”
The really problematic issue for
hedge funds is that the space has become too crowded. Carlson noted that
in 1998, there were about 3,200 hedge funds with roughly $210
billion in assets under management. Today, more than 11,000 hedge funds manage
more than $3 trillion in
assets.
“Size is the enemy of outperformance,” Carlson
notes. But I suspect it’s even worse than that: Hedge funds, like everything
else, follow Sturgeon’s Law that
“ninety percent of everything is crap.” In other words, the key to
outperformance is avoiding the detritus that infests the 90 percent and owning
the exceptional 10 percent. That, I’m afraid, is easier said than done.
This
column does not necessarily reflect the opinion of the editorial board or
Bloomberg LP and its owners.
1.
Asness was a guest
on Masters in Business in 2015, and was at
the evidence-based investing conference my
firm producedin New York last year.
2.
See “Higher risk, lower returns: What hedge fund investors
really earn,” by Ilia D. Dichev, Gwen Yu, Journal
of Financial Economics 100 (2011), pages 248–263.
3.
He has long been a critic of hedge funds for
a) charging too much; and b) for not hedging.
To contact the author of this story:
Barry Ritholtz at britholtz3@bloomberg.net
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