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Suspension of Disbelief

By: Frank Armstrong

By: Frank Armstrong, CFP, AIF, CLU

You can’t have escaped hearing about hedge funds. Wall Street is gearing up to provide registered product and fund of funds to the middle class investor. To hear the marketers tell it, they are the next big thing. The story sounds wonderful. All you have to do is suspend disbelief. Like Alice, you must simply believe six impossible things.

“Alice laughed, ‘There’s no use trying,’ she said, ‘one can’t believe impossible things.’ ‘I daresay you haven’t had much practice,” said the Queen. ‘When I was younger, I always did it for half an hour a day. Why, sometimes I’ve believed as many as six impossible things before breakfast.’ “*

There are serious questions of custody, transparency, risk control, disclosure and registration in almost every hedge fund. Let’s forget all that for a moment. That leaves us with one remaining nagging problem. But, it’s a Whopper: Where’s the beef?

Hedge funds claim to be able to deliver “absolute returns” that are not dependent on market performance, and are totally uncorrelated to the market. If they could do that, it would be the holy grail of the investment business. We could confidently plan on reducing risk while increasing returns.

In fact, the claims that hedge funds can deliver consistent liberal positive returns at a fraction of market risk are so seductive that if they could be believed, we all might consider putting all of our assets into them. Forgive me, but I’m not ready to sell everything, leverage up my hedge portfolio and sail away forever.

Depending on who is counting, there are between a dozen and 18 strategies that a hedge fund might employ. Every hedge fund strategy is by definition a “pure alpha” play. That is, the skill of the manager will generate positive returns no matter what happens in the market.

This assertion leaves us with the overarching question of Alpha. Most of the real world believes that Alpha does not exist – at least not in sufficient quantities to overcome the very real cost of trying to beat the market. If it exists at all, then the problem of identifying just who might generate a little of it in advance seems overwhelming. Forbes, Fortune and Morningstar, who all have enormous resources to devote to the problem, have been dismal failures.

No one else has cracked the problem either. For instance, with all the managers on the Fidelity bench, with all that they know about manager performance, you would think that it would have been an easy problem to select Peter Lynch’s successor. Yet this prince’s reign was short, brutish and dismal. (For what it’s worth, having failed big time at Magellan, he went on to manage a hedge fund! What am I missing here?)

One thing we know for certain, selecting managers based on past performance is a losing strategy. Again, if it exists at all, like a quark, alpha’s existence is fleeting. Today’s high flying hero is likely to crash and burn tomorrow. Yet, the fund of fund managers claim to be able to identify alpha generators based on past performance. Please repeat after me: “Past performance is no guarantee of future performance.” Now, keep saying it until it sinks in.

Hedge fund managers exist in a parallel universe. They disdainfully refer to stocks and bonds as “relative performance” vehicles, while they reside in the rarified world of “absolute performance”. The normal rules of risk and reward just don’t apply to them. They have escaped permanently from the capital market line. They float serenely above it, defying the gravity that constrains us mere mortals.

Perhaps my experience is unique, but I have never met an investor that prefers risk (relative return) to absolute positive liberal return. If my experience is typical then you have to wonder how risky asset classes could possibly endure in a world where high reward, low risk assets exist. No one would ever buy a stock or bond again.

In another leap of faith, we are asked to believe that superstar managers gravitate to the top of the industry where they should be richly rewarded. This reward schedule is typically one percent management fee plus 20 percent of profits, an obscenely high multiple of the compensation for mere mutual fund managers. The presumption is that none of the mutual fund managers are good enough to command this high compensation. It’s not a far stretch from that position to accept the idea that we can identify superior hedge fund managers by their level of compensation: they have to be good, or they couldn’t charge that much. The fundamental question of whether they got to that position due to skill, luck or great promotional skills is not addressed in the offering memorandums.

The fund of fund manager adds yet another level of fees. They are not at all shy about this additional cost. To hear it told, there is just no level of fees that might be excessive. Presumably diversification among sure fire hedge fund managers will reduce risk to insignificant amounts while prudent selection based on past performance will enhance returns.

Hedge fund managers often have a chunk of their own capital invested along side the client’s funds. A great deal is made of the commonality of interests this should create. However, the risk reward trade-offs for the client and the manager are not remotely the same. True, the manager risks some of his own capital. But with the management fee along with 20% of the profits of a huge pool of money the manager has an opportunity to truly strike it rich. The manager’s own share of the profits on his contribution is a fly speck by comparison. The leverage is enormous. If the fund is not successful, the manager will shut it down and start another one. Sooner or later, that leverage will provide a windfall for the manager even if most of the participants have meager results.

In passing I should mention that all managers are presumed to have a stake in their fund’s performance. Should we believe that if we pay them a multiple of their present comp, that we will get better performance. In other words, do we believe that all those mutual fund managers are not trying because their compensation isn’t adequate? Or that they are all just plain dense?

It’s still very difficult to get complete data on hedge fund performance. Survivorship bias is a HUGE problem. Not all funds report, so the less successful funds are often not included in the results. Many of the least successful funds close and disappear from the data entirely. Yes, you might make money. Occasionally, because of the huge leverage some funds employ the returns may be staggering. But, there is also a pretty high chance that you can go down with the ship. For a complete discussion of hedge fund performance see: Hedge Funds: Risk and Return. Burton G. Malkiel and Atanu Saha

You are sure to be reminded that hedge funds were previously the preserve of the super rich. They will also point out that some well known endowment funds participate. So, you are supposed to be given the chance to participate alongside of Madonna and Harvard. This gives the subject a certain amount of cachet and snob appeal. Of course, a lot of those super rich got stiffed, a point that is seldom mentioned.

*”Alice in Wonder-land” Lewis Carroll