Friday, May 10, 2013

Of course "hedge funds" lose money

Matt O'Brien, one of my partners-in-crime over at the Atlantic, has a piece criticizing hedge fund managers who go on TV to advocate hard-money policies. (Joe Weisenthal has a similar piece.) I agree with the criticism. But Matt also calls hedge fund managers out for their poor investment performance. As this article from The Economist shows, super-expensive hedge funds have done terribly over the last decade, when compared with a simple low-cost diversified portfolio of stocks and bonds. Matt says: "Hey hedge fund guys, if you can't even beat the market, why should we trust you on policy issues?"

I think this latter criticism is a bit misplaced, for two reasons. The first (and less important) reason is that to evaluate hedge funds - or any investment - you need to look not only at the return, but at the risk. If hedge funds have higher return-to-risk ratios (such as Sharpe ratios) than a passive stock-bond portfolio, then they are a better investment. Why? Because in that case you can borrow money and invest it in hedge funds, and your leverage will increase the returns (and the risk) of the hedge fund investment. If the hedge funds have a higher Sharpe ratio than the passive portfolio, you can leverage up until your risk is the same as the passive portfolio but your return is higher. In that case, you will have beaten the market, even if the hedge funds in which you invested did not beat the market. A number of top hedge funds have earned lower returns than the market since the financial crisis, but with much lower risk.


Now, I said that this is the "less important" reason. This is because even after adjusting for risk, hedge funds as a class probably underperformed the market. And they can be expected to continue to underperform the market, as a class. But that's just because hedge funds as a class are not particularly special, interesting, valuable, or desirable.

What is a "hedge fund"? It's a legal category, like "mutual fund". The "hedge fund" category is basically a "none of the above" legal category, meaning that hedge funds, alone among money management companies, have essentially no restrictions on the kinds of assets they are allowed to trade. To start a hedge fund, all you have to do is be a "qualified investor" with $5 million in capital, or be a "sophisticated investor". That means that as a hedge fund you can be essentially any Tom, Dick, or Harry, and you can try essentially any strategy. You could have macaque monkeys pick stocks and call it a "hedge fund". The catch-all "hedge fund" category attracts many of the best ideas in the investing world, but also many of the worst. And there's a lot more bad ideas than good ones. And you can't just tell which is bad and which is good by looking at size and fame, because many of the bad ones get lucky and get some temporary good returns, which results in people handing them giant wads of cash (which they then proceed to lose, while taking a giant fee).

Thus, just throwing your money at anything that is called a "hedge fund", just because you have heard that some "hedge funds" have managed to earn spectacular returns, is an extraordinarily bad idea.To put it another way: Anthony Scaramucci, organizer of the SALT hedge fund conference in Las Vegas, writes: "Mutual funds are the propeller planes, while hedge funds are the fighter jets." But that's not true. Some of them really are fighter jets. And some of them are beat-up old pickup trucks covered in papier-mache to make them look like fighter jets from a distance. And you aren't allowed to get anywhere near the planes to touch them and see which is which. And you forgot your glasses.

Anyway, I'm sure many rich people do invest in anything called a "hedge fund", but they're just throwing their money away (fortunately they have plenty to spare). But if America's pension funds, mutual funds, and insurance companies are doing this, then we have a problem.

In any case, we shouldn't be surprised that hedge funds as a class have been getting crappy returns of late. In fact, we've seen this sort of pattern before. In the 1990s, "venture capital" firms earned amazing returns, and a bunch of people heard about it and started throwing their money at anything that called itself a "venture capital" fund. New funds flooded the field to take advantage of this inflow of dumb money. Returns subsequently collapsed and have not recovered, though the old established firms continued making outsized returns (but stopped taking new investments, because when you get big it's harder to grow fast). The same thing happened with "private equity" (leveraged buyout) firms, who made a killing in the 00s but have not been doing so well since. And the same thing probably happened with mutual funds, back in the 60s when they became prominent and earned a lot of money.

So there is a very interesting behavioral story going on here. Why do people hurl their money blindly at the flavor-of-the-week money-management company category? Why do they fail to understand that there are good and bad hedge funds, just like there are good and bad architects or doctors or web designers? I don't know, but it's a fertile topic for behavioral finance research.

(And as a final note, the big worry when investing in hedge funds should probably be fees, not past performance. Even the best hedge funds may charge you such high fees that the extra returns they earn you get eaten up. So watch out.)

Back to the original subject, though. Matt shouldn't castigate "hedge funds" as a whole for making crappy returns, because it's just a legal category, not a hive mind. But his basic point stands anyway. You shouldn't trust hedge fund guys on policy issues. In fact, he even understates his case. Even if a hedge fund guy makes more money than God, year in and year out, you shouldn't trust him on policy issues any more than a highly successful physicist or heart surgeon or poker player. A money management company is not a nation-state.

Update: On Twitter, Giorgio Vitale brought to my attention the fact that the graph Matt shows is not actually hedge fund returns (those are often undisclosed), but the returns on an index that tries to track broad hedge-fund performance. That's good to know, though my points all still apply...


  1. Anonymous5:41 PM

    That last line is the money shot.

  2. "A money management company is not a nation-state".

    You're forgetting the Rothschilds, man. The Federal Reserve, too. I heard Bernanke has his own army. Read Zero Hedge much?

    1. Anonymous10:58 PM

      I read it and have never heard of such an Army. Luny comments don't count

  3. If buying a hedge fund on leverage would, in an ex-ante foreseeable way, consistently increase your returns at a tolerable level of risk, why didn't the hedge fund use more leverage itself? This seems to hinge on a superiority of insight on the part of the buyer compared to the HF manager, in which case maybe he should just be managing his own money directly.

    Another thing though: hedge funds typically manage enormously large sums of money, which introduces major complications when it comes to buying and selling securities in bulk. Hedge funds constantly need to be on guard not to get front-run by more agile market participants when they place their bets. This probably eats into their profitability in non-negligible ways.

  4. Fees are definitely the biggest issue there, and they tend to be a hazard with all actively managed funds. You're technically not getting ripped off since you're still making money off of it (hopefully), but it can still be worst than the passive fund.

  5. Side-note, but it looks like Abe has backed off on reforms of Japanese labor laws. Not surprising - when the economy appears to be turning up, why bother pushing for something that might kick people into unemployment?

  6. Anonymous7:54 AM

    They are not leveraged more because their Sharpe ratio would then be lower and not as attractive to investors. Additionally every hedge fund manager has a risk profile that he/she feels comfortable with and that dictates their leverage to a large extent.

  7. Anonymous8:38 AM

    As an addendum to my last comment:

    "Those who can, do. Those who can't, write for The Atlantic."

  8. Anonymous8:43 AM

    Another classic tactic of the left (and neocon right):

    If a money manager who advocates responsible monetary policy makes a killing by front-running and shorting the Fed's ridiculous policies, then he's a hypocrite because he gets rich off of soft money.

    Conversely, if a money manager who advocates responsible monetary policy underperforms the QE-steroid-pumped market (often because his philosophy is to avoid its soft money-induced volatility), then he's an idiot and not qualified to criticize anything to do with finance.

    Such is the left (and neocon right's) genius for sophistry.

    1. Sounds like the Chicago school too... if you're right you're a genius and deserve the Nobel prize, if you're wrong there's clearly a nefarious government intervention at work.

      They overlap a little with neocon right (but not strictly equivalent)

    2. Anonymous12:30 PM

      What if doesn't make money because predictions based on his hard-money ideology don't come true?

  9. And there's this too, from an actual former trader (hat tip Mark Thoma). Think about what this does to the risk-return trade off for the investor:

    "Here is a guaranteed way to get paid well if you work on Wall Street. Find a best friend at a competing bank or hedge fund and take opposite sides of the same large bet. In one year’s time one of you will have a huge profit and get paid well. The other person will have lost and perhaps be fired. The sum of both your profits will be zero, but the sum of what you get paid will be positive. Split the pay.

    This scheme is one of the more fanciful ways to exploit Wall Street’s compensation structure that pays absurdly well in the good years and just okay in the bad years. Losing money never means having to give anything back.

    That asymmetry in pay (money for profits, flat for losses) is the engine behind many of Wall Street’s mistakes. It rewards short-term gains without regard to long-term consequences. The results? The over-reliance on excessive leverage, banks that are loaded with opaque financial products, and trading models that are flawed."


  10. And:

    "The incentives are clear. If you make a bunch of money you get personally wealthy. If you lose then you just go home and look for a new job.

    Losing lots of money is hardly the career ender that outsiders imagine. If traders lose big then they will get fired, but they will now have experience. If one loses really big then one has almost a badge of honor. One could not be allowed to lose $1 billion unless one was really important.

    Wall Street is littered with traders who have “blown up” at multiple establishments or funds. There are enough to fill up a town about the size of, well, Westhampton.

    Here is a more conventional blueprint to personal wealth via Wall Street.

    Join a business that has an established track record. Start small, building up a few solid years of making decent profits. Do this for six or seven years. It’s called “milking the franchise.” Soon you will have respect and, most of all, expanded limits on what you can trade. Wait for a year when everyone is bullish. Then swing big. Really big. Don’t take judicious risk; take the most risk the firm will allow you. Follow the momentum, piling into trades others are doing.

    If you win, since you followed the herd, Wall Street will be flush with cash and you will get paid well, tens of millions well. If you lose you may get fired, but since everyone lost they will understand.

    This strategy is certainly not in the long-term interest of the firm, but it’s the smartest strategy to benefit the trader."


  11. Anonymous11:20 AM

    you seem to semi-defend the 'good hedge funds'.

    be aware that if you compare a hedge fund index to a broad stock-bond index, that is fair. But if you are going to select only the 'good' hedge funds - then you should select on the 'good' segments of the comparable stock-bond index.

    Said another way, hedge fund investors will argue that THEIR hedge fund beat the broad index --- but many, many ETFs are beating the broad index too. it means nothing.

  12. Anonymous5:15 PM

    [S]uper-expensive hedge funds have done terribly over the last decade, when compared with a simple low-cost diversified portfolio of stocks and bonds.

    There's a paradox here that I've been wondering about for a while. Based on the efficient markets hypothesis, you'd expect hedge funds to perform no better than a tracker fund. But, if the market were overwhelmed by tracker funds, there would be nothing to connect a company's fundamentals to its share price.

    (There's an obvious snarky response that hedgies aren't much good at that either, but I'll let that rest for now...)

    You'd expect this to lead to a sort of cyclical relationship. Hedge funds feed off the difference between market price and fundamentals-based price, until the difference between the two gets too small for much profit to be made. At that point, tracker funds move into the ascendant, feeding off the flow of information the hedge funds have created. Until eventually the number of active funds drops off enough that the market price decouples from the fair value again, and the cycle repeats.

    One possible conclusion is that we're not being fair to the hedgies here. If we measure performance at the right point in the cycle, we can trivially make them look worse than passive funds. If we picked another point in the cycle, they would look better.

    However, another possible conclusion is that, since the hedge fund boom seems to be pretty much permanent, there is something interfering with this dynamic. For example, I can imagine that investors might have a strong preference for active funds because of gambler-style cognitive biases.

    I've been thinking about this for a while, but it's all very speculative. Does anyone know if this is something that real economists have previously looked into?

  13. Golden Horse Wealth Management (GHWM) is a private equity firm that also runs its own hedge fund with a successful track record in derivatives, currencies and commodities.

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  14. "If the hedge funds have a higher Sharpe ratio than the passive portfolio, you can leverage up until your risk is the same as the passive portfolio but your return is higher." Good Lord, you think that's the causality?

  15. Noah,
    I'm just wondering how you can decide (from the outside) what risk the hedge is actually taking. If there is no way of knowing the real risk, why is it relevant in evaluating results.

    1. This is an excellent question, and goes deeper than you may can risk ever be known ex ante??

  16. Hedge funds are riddled with insider trading and backroom deals. I do think that holding everyone responsible for insider trading would go a long way into correcting this behavior. There was an article about this somewhere on but i cant seem to find it. I'll reply to this post if I can locate it. Anyway, the practice as it stands is not good for the economy and something has to be done.