Sunday, July 08, 2012

The Hedge Fund Mirage

Bounded rationality even for the most "sophisticated" capital allocators of all: pension funds, wealthy individuals, private wealth managers. Financial services are incorrectly priced, both by sophisticated investors, and by society.

See also The truth about venture capital.

If you are interested in a sick story, search on Alphonse Fletcher or on Alphonse Fletcher chair gates west pao  :-(

Economist: “The Hedge Fund Mirage” attacks the Wall Street worshippers’ blind adulation. Simon Lack, who spent 23 years at JPMorgan, an investment bank, selecting hedge funds to invest in, grew tired of the free hand that investors all too often gave managers. He has written a provocative book questioning a central tenet of the hedge-fund industry: its performance is always worth paying for. The promise of superior performance is wrong, he says. Of course some investors make a killing, but on average hedge funds have underperformed even risk-free Treasury bills. This is because the bulk of investors’ capital has flooded in over the past ten years, whereas hedge funds performed best when the industry was smaller than it is now. What is more, it is hard to know how hedge funds actually fare, since indices that track industry performance tend to overstate the returns. Funds that do badly or implode are not usually included in the indices at all.  
Why would any client continue to pay for such mediocre returns? One reason is that hedge-fund managers are incredibly good salesmen. In addition, industry insiders who are all too aware of hedge funds’ shortcomings choose not to expose them, Mr Lack argues. Moreover, the common fee structure, in which hedge-fund managers keep 2% of assets as a “management” fee to cover expenses and 20% of profits generated by performance, has made many managers rich, but not their clients. Mr Lack calculates that hedge-fund managers have kept around 84% of profits generated, with investors only getting 16% since 1998. “Where are the customers’ yachts?” is the title of one chapter. What is worse, the disastrous dive of equity markets in 2008 may have wiped out all the profits that hedge funds have ever generated for investors.  
Mr Lack places a good deal of the blame for this on investors who fail to ask tough enough questions and have not grasped that they “want yesterday’s returns without yesterday’s risk”. They invest money with the biggest, best-known funds “that look nothing like those whose aggregate performance” they want to emulate. Instead investors should stand up to managers, negotiate more favourable terms and put their money into smaller funds, which tend to perform better.


David Coughlin said...

There's a thermodynamical-free-energy analogy in there that I would love to see made explicit...

LondonYoung said...

''Bounded rationality even for the most "sophisticated" capital allocators of all: pension funds, wealthy individuals, private wealth managers.''
Hmmm, I kinda think the middle group does better than the other two.
The agents at the other two groups are often rewarded based on how many good years they have vs bad years.
The agents in the middle group are rewarded based on the compounded average.
Since the performance structure is typcially "most years good but an occasional whopper of a loss".
So, at least these sets of agents are acting "correctly".
However, maybe better to ask why the ultimate beneficiaries of Calpers are unable to get Calpers to stop investing in hedge funds ...

steve hsu said...

Even if the Agents' incentives are biased so that they are actually acting rationally, the people (also supposedly sophisticaed) who employ them are clearly not making the right decisions.

I don't believe all the Agents are in the know here. For example, in the Kauffman Foundation report on VC returns I linked to earlier, the Kauffman researchers seem genuinely surprised at how poorly their foundation has been doing with VC investments -- and these guys are experts on VC and startups.

MtMoru said...

One problem with this analysis is that "the market" has become dominated by the decisions of professional investment advisers.

No one can jump higher than he can jump.

LondonYoung said...

As I've said before, a simple beta/alpha analysis if major hedge fund indices demonstrates negatives alpha. All of us can independently verify this. So, why is it that people we know can do this analysis still invest? Ignorance does not seem like a believable answer.

steve hsu said...

I think many people are irrationally overconfident. So they think they can pick the one hedgie out of many who actually has alpha, even though they may understand (at the rational level) that most do not. It doesn't help that the hedgies are very good at portraying themselves as having special magic.

Why do admissions people at elite schools think they can predict college performance better than a simple linear combination of SAT + HSGPA? (When in fact the opposite is true.)

Why do economists think they can understand/predict the economy when empirically it is clear they cannot?

My son thought he had a way of rolling dice that increases the probability of his desired outcome. I made him look at the statistics but he's only six, after all ;-)

LondonYoung said...

some ill informed responses:1) admissions: professors *don't* really think that they are predicting performance - they just aren't optimizing for that - they have other goals in mind
2) economists: kinda similar,except they are better at fooling themselves, they manipulate themselves into thinking their predictions are good when, in fact, they are predictably skewed (but different economists have different motivations and thus different skews) Their skews match what is good for them

and a better informed response:
3) your son is learning

I agree people are overconfident, but I am not sure I agree they are irrationally overconfident - they have good reasons
I think the agents speculating on hedge funds are individually benefiting.
I am pretty certain that the people I know investing their own money do not make this mistake. For example,zero of my own money (what I control) is invested in 2 and 20 hedge funds, and I bet zero of your own money is too, right???? QED

David Backus said...

Interesting. Some thoughts: (i) Hedge funds and vc are recent, takes some time to learn about the costs and benefits. Esp true when return distributions are highly skewed, so this could be a transient phenomenon. (ii) Academics in finance (not me) have been saying for decades (back to the 60s?) that diversified portfolios with low cost are the best bet. The evidence is pretty strong, but no one seems to like that, people always want a better deal, even though on average they get worse. Human nature? Maybe. At least the share of index funds has gone up.

steve hsu said...

1) I know admissions people have other goals in mind, but if you ask them (as has been done in studies) whether they think they can predict GPA performance (which is easy to measure), it turns out they are wildly wrong. They could be wrong about the other things as well but that's harder to measure.

I don't have any 2/20 investments. I almost put some money with Renaissance (not Medallion, that's closed) but decided against it. However, you and I may be exceptions. Somebody is putting up the trillions under 2/20 mgmt!

steve hsu said...

I say human nature. There will always be Madoffs, con men, trendy funds, etc. preying on greed and overconfidence.

Also, what's the minimum g required to deeply understand (and have your behavior modified by) statistical results in portfolio theory? Even among rich people or those who control a lot of capital there will be many below this threshold.

I suspect that not only are individual investors and pension funds overpaying for financial services (e.g., 2/20), but *society as a whole* is overpaying for what it gets out of the financial services industry in total.

David Coughlin said...

How many people over 40 do you know who respond to any stimulus to change their behavior?

5371 said...

What was the sick part of that story? Litigious? Alleged fraudster? Changed teams? I'm missing something.

David Versace said...

Doublethink and all that Steve. There is a reason the inner party excels at it, it's necessary. Try not to ignore the fact that people are people, even really smart people.

steve hsu said...

Read a bit further in for more about how he runs his funds and how gullible his investors were.

Scott Locklin said...

Most hedge funds are baloney. Take your S&P returns time series. Lever by two. Remove 2% and 20% excess, and, well, that tells most of the story. They serve a purpose, but mostly seem to be rent-seekers. Mutual funds are arguably worse.

David Coughlin said...

Digging back into this, just to grind my axe. The concept of rationality as it is explicated by the game-theorists and economics is phony. A rational actor is someone who is blind and without memory. It makes the games easy to analyze, but not sensible in their outcomes. As you guys have noted, an actor has to be put in his time and place, with his capabilities understood before you can decide if they are truly rational, vis-a-vis acting on 'best' decisions. As a grown up, I have a rough line on my world maybe two years out. After that, I might as well just be rolling dice [but not against your son]. Twenty years ago, I couldn't even figure out what I should be doing a month out, so progress is progress.

MtMoru said...

At least one other person who knows 1984 isn't about Stalinism.

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