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You Are The Sucker, And Apparently You Love It

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To return to a favorite subject, the amount of money sophisticated investors throw into hedge funds continues to astound me:

The average hedge fund has gained just 0.3 percent this year, according to HFR’s weighted composite index. That is enough to outpace the 0.75 percent decline this year in the Standard & Poor’s 500-stock index.

Given the staggering amount of fees that hedge fund managers generally charge, this is a terrible return. You would be better off picking stocks from the S&P 500 at random and much better off investing in an index fund.

But wait: this has been a relatively good year:

On that score, however, 2015 has been the exception. The broad hedge fund index has underperformed the stock market in America the previous six years.

Paying somebody massive commissions to do worse than throwing darts at the Wall Street Journal indexes is nutty. And the performance isn’t surprising, since there just aren’t that many foreseeably huge arbitrage opportunities out there:

Take John A. Paulson, who made billions of dollars betting against the housing bubble in 2008 but is nursing losses in three funds this year. He is now raising money for two new funds: a private equity fund and a one focused on health care stocks.

Paulson deserves a good deal of credit for identifying the housing bubble and the implications of converting bad loans into allegedly safe securities ex ante when the correct view was the view of a relatively mall minority. But it’s not as if you can count on this happening on an annual basis. Sometimes the bubble you spot is a bubble. Sometimes it isn’t. Sometimes the market can stay irrational longer than you can stay solvent. Investing with someone on the basis that a good call can be routinely repeated, especially at steep costs, is a really bad idea.

And yet:

The recent fund-raising, however, underscores a bigger trend in the industry: Pension funds still want to invest in hedge funds, even as they complain about high fees and years of disappointing performance.

As long as you can keep finding the marks, there’s no need to stop the con.

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  • jim, some guy in iowa

    I dunno. the pension funds might just as well buy their own dartboards

    • Warren Terra

      I suspect people pitching hedge funds wine and dine pension fund managers rather better than the people pitching dart boards. And that’s without imputing actual kickbacks or insider trading scenarios …

  • Mike G

    Institutional funds are like ocean liners. They have huge sums of money to move around and can’t maneuver easily or quickly. They have their allocations decided in advance by committees that may take a long time to adjust to reality (this much hedge fund investments, this much AAA-rated bonds). Some are less astute than others in selecting good investments within those categories, it’s all about finding product to meet the allocation requirements. As seen with the CDO meltdown, Wall Street will create product that meets the letter of requirements even if it’s toxic crap (turning garbage mortgages into AAA-rated paper) because undiscriminating institutions will still buy it in big quantities.

    Like any slow, mediocre bureaucracy, the focus for money managers in these institutions is on adhering to allocation policy, no matter how bad or nonsensical, so that if the investments go bad your butt is covered.

    • efgoldman

      even if it’s toxic crap (turning garbage mortgages into AAA-rated paper)

      But the way they did that is to corrupt the ratings agencies. They didn’t really turn anything into anything.
      Except profits.

  • Mellano

    “… Todd E. Petzel, chief investment officer at the private wealth management firm Offit Capital, who added that most consulting firms employed by large institutional investors continue to recommend allocating money to hedge funds.

    In light of that perspective, he said: “The question then becomes, What do you do with a hedge fund that disappoints over a long period of time? You substitute out.”

    I expect the consultants and hedge fund managers have provided very comprehensive steak dinners, I mean spreadsheets, that demonstrate how “substitute out” means something other than “sell low, buy high.”

    • efgoldman

      I expect the consultants and hedge fund managers have provided very comprehensive steak dinners, I mean spreadsheets

      Cleverly disguised, among other things, as very hard to get, expensive theater and sports tickets, and in some cases, compliant young women(or men, as the case may be).

  • Murc

    I’ve always chalked this up to institutional investors wanting to simultaneously invest conservatively (because unlike actual venture capitalists they can’t just shrug and walk away if they pour 100 million into a venture that implodes) but feeling like they need to have at least the possibility of generating above-market returns.

    The problem with that is that bankers are actually, in some ways, very good at their jobs (please not that I heavily qualified that sentence) and as Scott says, there just aren’t that many foreseeable huge arbitrage opportunities out there; the only way to generate above-market returns is to take high risks for high gain. This is, in fact, the way capital markets are supposed to work. It’s largely the way they have to work; nobody would ever invest in anything new, risky, and innovative if they could just park their money someplace safe and watch it generate sky-high returns. Part of the reason the Fed lowers interest rates when times get bad is to stop people with giant wads of cash from just parking it somewhere safe and still generating returns.

    But I digress. Index funds never, ever have a chance of beating the market, whereas hedge funds, though sheer dumb luck more than anything else most of the time, sometimes do. And while hedge funds often preform poorly they don’t often preform catastrophically poorly; they’re regarded as safe. (Hell, it’s even in the name; “hedge.”)

    So there’s always institutional investors looking to park their stuff there in the hopes they’ll generate above-market returns, because the alternative is to be dull and safe, and investors don’t want a reputation as dull and safe, they want to be known as shrewd money-makers. And slowly grinding away over a half-century to generate rates of return of around 2% after inflation… well, that’s a very 20th century way of banking, ain’t it?

    • djw

      I don’t necessarily doubt your explanation, but it really does emphasize how this really is just gambling all the way down.

      I enjoy gambling, myself, but *I* actually enjoy doing it, not paying some asshole to do it for me, win or lose.

      • Murc

        I don’t necessarily doubt your explanation, but it really does emphasize how this really is just gambling all the way down.

        It is, yes. I just take that as a given. I imagine most of these masters of the universe would retort “This isn’t gambling, it’s a calculated risk! There’s a difference!”

        And, well, no, there really isn’t, buddy. REAL investors take calculated risks; they become experts in their subject matter before carefully deciding “this company looks like it is doing something that will generate actual profits and a good return.” And even those guys lose a lot, which they’re prepared to do. That’s a calculated risk.

        Trying to beat the market, which is really what a lot of so-called investors are trying to do, isn’t really investing. It’s not even risk management; it’s just straight-up gambling. You’re trying to beat the house. Worse, you think you’re trying to beat the house at poker (doable but really fucking hard) when you’re really trying to beat it at the roulette wheel (ahahahahahano).

        • Manju

          I’m not sure what you’re saying. You got the real investors who take calculated risks vs the so-called investors who are trying to beat the market.

          But real investors are trying to beat the market too.

          Perhaps you are contrasting those who become experts in their subject matter (real investors) vs arbitragers (who do not study companies per se, but rather base their picks on a financial model)?

          • sonamib

            Perhaps you are contrasting those who become experts in their subject matter (real investors) vs arbitragers (who do not study companies per se, but rather base their picks on a financial model)?

            This distinction is important*. I think relying only on financial models won’t cut it nowadays because everyone uses those, no one’s got a special advantage here. If you want to beat the market, you have to know more than the typical investor about what you’re investing in. That means specializing in some subset of the market and learning a lot about it.

            The crux of the matter is that most investors are experts in financial theory. There are only marginal gains to be had by becoming even better at it. But very few people know what makes, say, an organic supermarket** successful, so you might gain an advantage by specializing in this.

            *I’m pretty sure Murc was doing it too.

            **totally random example

          • Murc

            But real investors are trying to beat the market too.

            This may be the case in a technical sense (I’m not up on the precise meaning of terms) but I don’t consider investors of that sort to be trying to beat the market unless we’re defining all investment activity to be trying to bear the market, which seems less than useful.

            In fact, venture capitalists of the sort I’m thinking of largely don’t interact with the market as we think of it, because by the time a company goes public that investment window has passed. If I had a couple hundred million and thought that, say, Uber (to pick an example at random) had a business model that had real legs and a plausible claim to profitability or at least high revenue, I could give them my moneys and say “Grow your business, and when you get big I’ll make a nice return.” But what I can’t do it add it to my hedge fund basket or play arbitrage games with it in the context of the wider transportation industry market, because it is privately held and I cannot buy its stock on the open market.

            I think there’s a genuine, meaningful difference between “I’m headed to the casino with a mathematical model that I’m going to try and use to extract wealth at the margins” and “This guy seems like he’s invented a better widget; imma give him some cash money to build those widgets and we’ll both end up ahead.”

        • mpowell

          Your first point was better than your second. There is no such thing as ‘the market’ that we can use as a bulletproof benchmark. I’ve never heard of anyone advocating passive index investing who doesn’t also talk about asset allocation. And the purpose there is to improve your returns by searching for less correlated returns and also to adopt a risk/reward posture that matches your needs. If someone is just buying S&P500 index funds they’re just being lazy about it. And that might be fine for someone with $100K in savings to invest (is it really worth doing research annually to eke out an extra 0.2%?), but is not at all okay for someone managing an institutional fund with $100M.

          So hedge funds sell themselves to this crowd as a means of diversification. Reducing correlation in returns is actually really hard. But if you want to invest in this asset category, you are stuck picking winners and losers (no decent equivalent of an index fund). This doesn’t mean that hedge funds are a good investment, but the picture is a lot murkier than you make it out to be and the motivation of the investors more complicated.

          • Brett

            There are hedge funds of funds . . .

          • howard

            this is what people tell themselves, but i’m far from convinced that it’s true.

            “institutional investors” – philanthropies, universities, etc. – are the precise people who should have a long-term perspective.

            and from a long-term perspective, 100% of your money in a low-cost index fund is quite likely to net you out ahead over any other strategy: the cost of diversification is very real, it doesn’t come for free.

            now for you and me, diversification does have some logic: if i was about to retire in 2008 and i had everything in an s+p 500 index, i’d have had (as many did) the sol blues, so there’s nothing wrong with the principle.

            but a charitable organization or non-profit or university that has every expectation of lasting to an infinite horizon doesn’t have the same considerations: the entire thinking should be long-term.

            • Mellano

              Yes, BUT institutional investors by definition also have short term obligations. Pension benefits, annual spending requirements — they have to account for more than simply growing a giant pile of assets in an indefinite future. That plus handling large numbers means there is work to be done with asset allocation. But that work also doesn’t require sexy, high-fee funds promising alpha or “smart beta” or whatever the current grifting pitch is.

          • djw

            If Piketty is right, massive institutional funds are ‘beating the market’ insofar as the return on capital is notably greater for very large investors. It’d be very interesting to know more about the precise processes involved there.

            Given what we know, I don’t really see how it’s “lazy” to not make a bet you know isn’t likely to win, relative to a safer bet.

      • howard

        there are two broad categories that apply here: speculating and investing.

        a lot of people tell themselves they are investing when they are speculating….

    • efgoldman

      And while hedge funds often preform poorly they don’t often preform catastrophically poorly; they’re regarded as safe.

      Well, it’s one thing if you care paying a fee-based advisor a quarterly percentage; the better your portfolio does, the more money the advisor makes, which is a fair bargain. It’s another thing altogether if you’re paying management fees, AND commissions, AND an advisory fee before you make a dime for yourself or your pension fund.
      I retired in July from a huge firm that sold both no-load funds (directly to the public) and commissionable funds, through brokers and agents. I never, ever understood why someone would pay 4% to 5.5% off the top to buy essentially the same fund that they could walk in off the street and buy for themselves.

      • Xenos

        A lot of people won’t invest in anything unless it is sold to them. It is actually a lot of work to get up to speed on how to invest sensibly, and unless someone is works in or is very familiar with the mutual fund industry it is all pretty overwhelming.

        Your company did not make more money off the front-loaded funds. The product is just not going to move otherwise.

        • Brett

          I always thought that was a big part of the appeal of hedge funds to rich investors, and maybe to the folks running some of the institutional funds as well. “You got to get in on this sweet, exclusive deal we’ve got for you, getting returns better than what those chumps sitting on index funds are getting”. Rich folks especially love being sold on how special they are.

    • howard

      btw, interestingly enough, when hedge funds were first invented in the ’60s, they were called “hedged” funds, because the original premise of the original hedge funds was to offset all your longs with shorts.

      over time, the “d” disappeared and so did the idea of hedge funds as simply long/short offsets.

      • JonH

        I would guess that function has been replaced by more complicated derivatives.

        • efgoldman

          I would guess that function has been replaced by more complicated derivatives.

          Algorithms. Whole damned world runs on algorithms.

  • Xenos

    I work in the trust industry in Luxembourg, managing the investment vehicles used by private equity houses and investment funds to invest in Europe. Most are legit investments, some are not well justified except as a rather expensive way to funnel profits around with limited or no tax withholding.

    More and more I am seeing private equity businesses expanding into hedge fund deals, hedge funds trying to take publicly traded companies private, and both looking for ways to get into new investments. I do not think either industry is having much luck in their traditional investments and are branching out due to desperation. Too much competition, and, in general, not nearly enough volatility out there for them to make a killing.

    This is why these guys love Republicans – all that craziness and instability creates the environment they need in order to thrive.

    As for how they keep getting investors, where is are the large institutional investors going to go? They need to invest the money and they desperately need to make a little return in order to justify their phony-baloney jobs as highly compensated professionals in the non-profit sector. At least if they hire Bain to lose money for them they are not going to be fired for incompetence. It is just bad luck!

    • TheDeadlyShoe

      that last par is exactly what came to mind for me.

      if your job is to invest money, you ain’t ever gonna say investing is a bad idea right now.

    • fledermaus

      There’s only so many places to invest hundreds of millions of dollars.

  • Judas Peckerwood

    I sleep well at night having nothing directly invested in The Market. Yeah, I know that I’m connected by having money in savings, traditional IRAs, real estate and whatnot. But not being intimately tied to the Grand Casino is a fine thing.

    • Cassiodorus

      Unless your IRA is in some really unusual stuff you are definitely exposed to the market.

  • Brett

    This is a bit off-topic, but watching that video, I realized two things:

    1. Matthew McConnaughey is going to make an amazing Randall Flagg in the new The Stand movie, and

    2. He’d be great as Jack Torrance if they ever do a mass-release Shining movie again.

    • The still in the preview of McConaughey is awesome.

    • Manju

      Who needs the Shining when you got those Lincoln ads?

      • In those Lincoln ads, he’s awfully similar to Rust Cohle.

        • Manju

          Between his car ads and Bob Dylan’s, I don’t know whats going on. Tom Waits is probably wondering why Tesla hasn’t called.

          • Nobdy

            To be fair, Matthew McConaughey did star in a movie called the Lincoln Lawyer, so at the time he was a logical spokesperson.

        • JonH

          “Lincoln. If you get the opportunity, you should kill yourself.”

    • UserGoogol

      Now that I think of it, Matthew McConaughey kind of looks like Steven Weber.

    • Halloween Jack

      He’s also being looked at for the Man in Black in the Dark Tower miniseries, as is Idris Elba for Roland.

  • Nobdy

    Some back of the envelope calculations for people who don’t know just how bad the 2 and 20 (2 percent of assets, 20 percent of profits) deal is.

    Let’s say you invest $100,000 in a low-cost index fund. The market goes up 6% (a decent year). You now have about $105,788 (You paid .2% in fees).

    Now let’s say you invest $100,000 in Nobdy’s Super Genius Hedge fund. Since I am a super genius, I earn a 10% return! Yay! I’ve beaten the heck out of the market. You now have…$105,800! That’s right. Because my super genius beat the market by 4% absolute and by a 66% margin!!! you earned….$12.

    Let’s say instead I just match the market. You now have $102,680

    Yayyyy!

    Notice that in the first instance I earned $4,200 for making you that $12, and in the second I got a cool $3,320 while leaving you worse than an index fund. This is why hedge funds make hedge fund managers very rich.

    It’s also one of the reasons that hedge funds tend to do worse over time, but I’ll explain that in a separate post.

    • Nobdy

      Hedge funds do worse over time for two primary reasons.

      1) Survival bias. If you have 10 hedge funds and they are all relatively volatile, but the gains are distributed randomly, after 1 year you’ll likely have 5 that have gone up and 5 that have gone down. Of the 5 that have gone up the next year 2 or 3 will have gone up again (and the others will have regressed to the mean.) Now you have a Track Record for those 2 or 3 funds that made lots of money over two years. Investors are clamoring to get in! But it’s an illusion. It doesn’t demonstrate expertise, just luck.

      Now in the real world things aren’t QUITE that random, but they are pretty close, and you have a lot more than 10 hedge funds starting out. Some of them are going to go on impressive runs thanks to the laws of probability, and those will be your long-running superstar managers, and they will almost always regress to the mean. Humans look for patterns in the noise.

      As for the loser funds? They’ll get wound down. Hedge funds are constantly starting up and being wound down. More random experiments, more randomly determined Winners with Track Records, more people clamoring to get on board.

      2) It’s easier to be profitable when you’re smaller, but getting big is where the real money is. Posters above have said that arbitrage is hard, and it is, but it’s not impossible. What’s NEARLY impossible is arbitrage on a very large scale. If you have $50,000,000 to invest there are a ton of markets you can get in where either 1) You can dominate a very small niche market and make a nice profit; or 2) you can make moves in a very big market without being noticed or moving prices too much.

      An example of 1 might be that if you notice that there’s been a drought in a certain small area in Arizona and farmers there are going to need more water than usual, you buy up all the water rights without being noticed, gouge the farmers, earn big profits. These opportunities do exist, but they are hard to identify and often have limited investment opportunities (once you’ve bought up all the water rights for that area you can’t buy up any MORE water rights. You’ve exhausted the market.) A small fund can make money doing a few of these deals a year. For a big fund they are insignificant because making a 30% profit on a $50,000,000 investment doesn’t mean much if you have $5,000,000,000 under management.

      2) Let’s say instead of a localized drought in Arizona you notice that for some reason there’s a demographic dip coming in the elderly population in some country (because of war or disease that wiped out a chunk of a generation) so you want to short businesses that service the elderly there. As a small fund nobody pays attention to you can go around borrowing stock and making your short plays in a relatively stable market, since they are a small part of the trading activity. You make money. As a big fund, especially a famous one, it’s much harder. People get wind of what you’re doing. They see the fluctuations you are causing in the market. They adjust the prices and you make a lot less profit on margin because of those adjustments. Small and agile is very different from big and loud.

      HOWEVER, despite the advantages for small funds, the fact that the managers get paid a percentage of funds under management and profits means that it’s better to manage a big mediocre fund than a small but more effective one. Hedge funds are incentivized to grow larger than the size where they can actually be effective, even if their managers CAN spot opportunities and make smart arbitrage decisions.

      Yay!

      • CJColucci

        Everything I’ve read and heard tells me that almost everyone ought to have almost all their long-term money in low-cost index funds because anything else, like picking individual stocks, or expensive managed funds, eats up your returns — which will rarely beat your relevant index — in expenses. I find this convincing, but it raises a question to which I’ve never gotten an answer. If everybody did that, what would the index funds be an index of? What would make the individual components of the index move up and down?

        • Murc

          Stock price is theoretically supposed to reflect the health of the company. So there would still be movement in the market because of actual things happening in the real world.

          • CJColucci

            But from whom would the fund buy, and to whom would it sell when investors wanted to buy or sell? If nearly everyone owned index funds, would the market be too thin and illiquid for them to operate?

            • efgoldman

              But from whom would the fund buy, and to whom would it sell

              The way it works (using small amounts for clarity).
              You buy 100 shares of XYZ S&P 500 index fund for $10/share, = $1k (Assuming a no load fund).
              The fund takes your $1000, after the market closes and buys $1000 in the basket of 500 stocks (the index), using a proportional formula to account for price differences, splits, buybacks, etc.
              You now own $1000 of stocks in the S&P 500 index, in the same proportion.
              Tomorrow the S&P goes up 10%. Your fund shares are now worth $1100.
              The day after, the S&P has a no good, very bad day, and drops to $900. The value pf your shares drops.
              Next year, you decide to get out. At the close of business that day, the index is $1200. You get your money (lucky you) and, following the market close, when the closing prices of all the stocks are known, the fund sells a proportional amount from each security.
              Multiply that times thousands of account holders, buying, selling, and repricing every day.
              The market actually uses a net settlement process, only buying or selling the amount of shares necessary to balance the accounts. The funds have to wait until the end of business to price their shares, because the underlying securities have to be priced. Now, with interconnected main frame computers, it takes until about 600pm. It used to be done manually – can you imagine?

      • Bruce B.

        I really appreciate these kinds of explanation – the combination of solid info and some chatty snark makes it feel like listening to a real person telling me things. Thank you!

        • skate

          There is supposed to be a scene in “The Big Short” where some complex financial shenanigan is explained by a woman in a bubble bath. From what I’ve heard, the scene works pretty well.

    • Zamfir

      There’s a 0.3% number in the OP. I can’t figure out if that is before, or after costs?

      EDIT: clicking through to the FAQ of “HFR indices”, they say net of all fees.

  • mch

    OT. I keep waiting for either you or Paul — you more than Paul, given your Albany place in the world — to weigh in on Jonathan Lippmann’s retirement.

  • Dr. Ronnie James, DO

    “Paying somebody massive commissions to do worse than throwing darts at the Wall Street Journal indexes is nutty.”

    IIRC this also applies to mutual funds, one of the “safest” most “conservative” investments out there (who also make most of their money the day you buy in). So if the criterion above defines “racket”, then…the whole thing is mostly a racket? Doesn’t Atrios call Wall Street the dog track, or was that just the NYSE?

    • howard

      over a 10-year period, roughly 80-90% of mutual funds under-perform their benchmark, which is why warren buffett wants his wife (once he passes) to simply put the money into an s+p 500 ETF.

    • Srsly Dad Y

      You’re conflating terms here. The Vanguard index funds (for example) are all mutual funds, they don’t have front-end loads or high fees, and they never do worse than “average.” They are not a racket, you just need to know what they’re good for.

  • Jake the antisoshul soshulist

    I don’t know if was Pohl and Kornbluth who first called it, but there is a chapter in Gladiator-at-Law where the protagonist visits the New York Stock Exchange and Casino.

    And this might have been a better illustration.
    http://recruitingdaily.com/wp-content/uploads/sites/6/2015/11/77898_full.jpg

  • mombrava

    I read some hedge funder somewhere responding to exactly this kind of criticism by saying “But hedge funds are where all the big money is! All the best investors put their money here!” Which struck me as suggesting the exact opposite of what he meant to say. For some people, all you need is a vaguely plausible sales pitch and a fancy suit, evidence to the contrary be damned.

    • Murc

      “But hedge funds are where all the big money is!

      This is absolutely true, but it ignores the fact that there’s no reliable way to figure out which hedge fund is gonna hit big and which isn’t. It’s literally a roll of the dice.

      Some funds have tried to get around this by going down the rabbit hole and being “funds of funds.” At a certain point, risk management and diversification strategies actually do stop working, and those clever boots have reached it.

      • howard

        the great thing about the hedge “fund of funds” concept is you get to pay two, count ’em, two levels of fees, the original fees in the original hedge funds and then the fees on the fund of funds.

        and yet people do it….

    • Nobdy

      My favorite hedge fund defense is that they’re actually designed to “hedge” against bad markets. They grow less during boom times but do better during busts, thus helping maintain stability in a portfolio.

      This excuse works pretty well when hedge funds are underperforming in boom times, but less well when they implode during a bust because many are leveraged out the wazoo and are actually chasing big risky returns, not parked in safe, countercyclical assets.

      Of course you do get 5-7 years of solid excuse in between those busts, so that’s nice, and then when the crash comes you get to say “nobody saw this bubble coming” which may be true, but then what are you collecting your 2 and 20 for exactly?

  • howard

    the thing is, every year some hedge fund goes up 70%, and it’s amazing how many wealthy individuals a.) want that return and b.) believe that they can pick the hedge fund manager who is going to provide it.

  • JonH

    Even a losing investment has value as a tax write-off to offset income.

    • Scott Lemieux

      It’s still better for you to lose money to write if yourself rather than paying someone a massive fee to do it for you.

      • JonH

        I wouldn’t be surprised if sometimes the fees are rationalized as potentially buying access to separate non-hedge fund investment opportunities. This’d be the case for smaller, individual hedge fund investors, not the big accounts. Nouveau riche, etc, who aren’t plugged in to the old money old boys’ networks yet.

        Thus, when your money-losing hedge fund manager “knows a guy” who’s looking for investors in an arena football league, maybe..

        Okay, this isn’t likely to be profitable either.

        • Mellano

          The picture of an individual signing away money to a hedge fund is Fig. A in the argument that “you didn’t build that.”

          No cite offhand, but I’m pretty sure that the proverbial “2 and 20” is more likely to be paid by real suckers — instititions can negotiate lower fees, but individuals are probably paying whatever terms they’re offered.

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