Will hedge funds beat the market again?
I recently read an article which discussedthe fact that a majority of hedge funds may never beat the market again. The author's argument boils down to the fact that professional investors are more informed, more highly educated and more competitive than ever before. Yet they are all competing for a shrinking slice of the alpha pie:
It's not that managers have gotten dumber. It's precisely the opposite. The average manager is more skillful than in past years. The paradox of skill says that when the outcome of an activity combines skill and luck, as skill improves, luck becomes more important in shaping results.
To back up this assertion, he cites data:
In the initial 1998 to 2002 period, hedge funds actually earned their keep, producing alpha of 9 percent. Unfortunately, it didn't last long as investors showered these funds with capital following the severe bear market of 2000-2002. This performance chase shrunk the alpha earned by this group in the 2003-2007 period to -0.7 percent. Then from 2008-2012 alpha went negative to -4.5 percent. The increased competition and larger capital base made it nearly impossible for these funds to keep up their outperformance.
Although I understand the main premise of the article (hedge funds can only employ a finite amount of strategies), I disagree with it. What is the alpha against? It seems like the author is just using buzz words and a click bait title. I am wondering what your opinions regarding the article as well as your opinion regarding the future of hedge funds and hedge fund strategies themselves.
An interesting point that I believe was mentioned in another thread (can't recall what the title was unfortunately) was that a big issue is the rise of passive indexing/ETFs. Remember what alpha is on a basic level - if someone generates alpha (the "winner" on the trade), there had to have been a "loser" on the other end of that trade to make the alpha possible in the first place. With so much active management outflows into passive indexing, the universe of "losers" decreases such that alpha generation becomes harder. The only people left are the really smart active managers who can only compete with each other at that point. Since everyone is so well informed, alpha is naturally going to be way harder to generate. It will only get harder as more hedge funds exit the business, leaving only the smartest/strongest to consolidate.
I think hedge funds in equities will struggle to generate the returns of the past going forward, especially with the rise of quant/HFT strategies + electronic exchanges that make the market way more efficient relative to the past. I think hedge funds in FI or other less efficient asset classes can do okay (i.e. bonds are still largely traded OTC and FI ETFs don't always precisely match their benchmarks from what I understand so many market inefficiencies still exist there).
TL;DR in economics we know that high profit margin industries cause folks to enter the business which drives profits down. Eventually the industry goes through a shake out when too many firms come into the market. I think hedge funds are going through the industry life cycle like any other industry and that the business is simply maturing.
Very interesting insight.
"I think hedge funds in equities will struggle to generate the returns of the past going forward, especially with the rise of quant/HFT strategies + electronic exchanges that make the market way more efficient relative to the past. I think hedge funds in FI or other less efficient asset classes can do okay (i.e. bonds are still largely traded OTC and FI ETFs don't always precisely match their benchmarks from what I understand so many market inefficiencies still exist there)"
Hearing stuff like this makes it more appealing for young people like myself to go on the buyside in terms of credit.
This was in Seth Klarman's 2016 letter. Basically the rise of passive investing and ETF's will create more mispricings. On the horizon, uncertainty will create more opportunities for active management. Furthermore, if quantitative strategies (HFT and otherwise) fail to work in a non-QE, inflationary, bear market with rising rates (something they have little if any data to train on) then this will also create mispricings... and more opportunity. I posted a topic debating this last week if you're interested.
So basically is alpha hard to come by in a market that steadily only goes up? Yes, you can even write algos to make money. But what will happen when/if the dynamics change?
Very fair point - I don't think we will truly know if the "death of hedge funds" is upon us until we see market conditions drastically change (and see how active managers react). For me personally, I know I'm interested in eventually going buyside so I tell myself to assume the worst and that I'll have to be ultra competitive to make it in that space.
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