Are HFs useless?
I don't mean to offend or burst anyone's bubble, but as a student interested in finance long term I have a question that has now become a legitimate concern. Looking at the returns from the largest HFs over the last few years, it seems that the market has beaten almost all of them. As information becomes more accessible and the market becomes more efficient, is investing a dying industry - truly a "fugayzi, fugazi" if you will?
Back when information was asymmetric and not so easily accessible, hedge funds were great because they really had that informational edge.
Today, nah. Consistently underperform, exorbitant fees.
It’s almost as if the purpose of the more successful hedge funds is not to beat the market…
thx bro but I can buy treasuries myself lol!
And you would still be correlated to the market…
that's why you reinvest the coupon in slot machines
HF's job is to provide uncorrelated return on a risk-adjusted basis which the best ones do.
It's literally in the name. "Hedge" funds. Risk-adjusted returns is what they target, and the good funds do it well.
You know what you’re right. You burst my bubble. The whole multi trillion dollar industry is on the brink of collapse.
Very thoughtful analysis here; sounds like you'd be great for a HF role
Typical state school kid caliber question.
"PuRpoSe Is nOt To BeAt tHE MARkEt"
Yeah whatever, it's a coping mechanism they tell themselves. For the vast majority of investors, gaining total market gains at ~no fees is the far superior value proposition.
At least the MM shops have an edge. And PE levers returns. But SM shops are just gambling
FOUND THE GUY 🫵🫵🫵🤣🤣🤣 WHO DOESNT UNDERSTAND INVESTING 🤭🤭🤭OR MARKETS 😆😆😆
Cool, hedge funds aren’t for the “vast majority of investors”. They’re for institutional investors who for various reasons place a higher value on uncorrelated, risk adjusted returns.
Various reasons = legacy relationships with hedge funds
It's just not smart money man
This. For example, pension funds and endowments are major investors in hedge funds. They like uncorrelated returns because it would be a major problem for them if all their assets declined in unison while they make constant cash payouts to beneficiaries, which would force liquidations at market bottoms.
The data is clear that a 48%/32%/20% Equity/Debt/Alternatives portfolio provides the best risk adjusted return, with the lowest drawdown and shortest drawdown duration - thank you CFA!
I love the unabashed confidence of undergrads making broad statements about an entire industry they clearly do not understand. Bravo.
Using your logic: Bitcoin also beat the markets too. Guess investing in the markets is stupid, should only invest in bitcoin.
This blog post
Good read, enjoyed it tnx
Perfectly explained! I think the bone of contention is the high free market rate. This makes it look like underperformance because the majority of funds pitch stable returns and low volatility. The macro/equity funds like Soros, PTJ, the old SAC and such which basically shot for the moon are frowned upon by investors now or rather since the “institutionalisation” of HFs. I'll say this is because the investor pool mostly comprises of risk averse and frankly public funds (pensions, insurance and co.) That has basically hampered the desire for HFs to really shoot the lights out when they could easily satisfy their investors and still get paid with the “low” returns. What do you think?
To actually answer your question if you think about the whole concept of the L/S equity model at a very basic level you are going long stocks you think have unrecognized value and short stocks that are overvalued. Because you have both long and short positions, the market exposure or beta should decrease given that portfolios can be constructed such to reduce beta. Institutions will pay hedge funds to do the work to find value in businesses and make L/S investments as, in theory, these bets should be profitable regardless of what the market does providing a “hedge”. Whether this is actually what happens with many HFs is another question….but this was the model Alfred Jones developed and has been used for a long time now
I mean is private equity useless? Everyone has a fund now and there's finite amount of opportunities which means finite amount of alpha or outperformance. Is private credit useless? Lenders moving further and further out the risk spectrum to ensure they get deals?
I don't know if "useless" is the right word but to think that hedge funds don't serve a purpose in generating strong risk-adjusted returns based on a specific mandate is probably mis-guided.
Think of it this way: the reason pods have eaten everyone's lunch or why 3 years ago Tiger was doing the same was because of differences in risk mgmt. The entirety of the investment world can probably be boiled down to how adequately you can manage risk. The pods take no risk so it's pointless to benchmark them to indices, the index itself has a beta of 1 or a risk of 1 while the beta in a pod is close to 0. So sure you can invest in the market but it's inevitably higher risk - thought only being that it's cheaper vis a vis fees & "markets only seem to go up." We can argue why that may not always be the case but assuredly markets TEND to go up over a longer duration. With a beta of 1 and duration as long as you're comfortable taking average risk (assuming more dispersion than we have today), and you are comfortable with returns being 10-15% on average, that's totally fine. There are other investors who prefer the pod model because it's designed to be entirely risk averse, use leverage to size their smaller returns into bigger ones and charge higher fees for it. But the measured risk is theoretically lower.
On the other hand, for basically a decade every TMT tiger cub guy with a billion dollars DRAMATICALLY outperformed the market. And almost every year. There was seldom a time where Tiger / Viking / Lone Pine or whomever wasn't beating the mkt, again likely with a beta higher than 1 but high risk/high reward. That model has been somewhat exposed more recently because of 2022, higher rates, poor risk mgmt, lack of awareness on the macro, etc. But if your view is that markets should and/or have to go higher then most TMT funds should lead the way if they know what they're doing, but the idea is the beta > 1 indicates that in a down year they can be down doubly as bad as the market (so far more asymmetric r/r, again in theory)
I do think the notion where info becomes more accessible eradicates the edge that some folks have but in reality that's been happening for a decade and I think the trickier piece now is you have excess amounts of concentration in indices making it exceedingly difficult to beat the mkt and secondly you have an insane amount of capital flowing to the existing pods/new pod launches... which just means more capital for a fixed amount of alpha available, should result in some erosion
Everything in all investment businesses are cyclical to a degree. The pods will have their time right now and eventually they'll lose out again to Tiger, and then vice versa, the same way private equity will go through those peaks and troughs as well in both returns and supply/demand for those vehicles.
Great post. Question — you said this:
(more allocation to market neutral strategies) which just means more capital for a fixed amount of alpha available, should result in some erosion
Are you saying that as more and more capital flows into pod shops, their advantage (total positive alpha) goes toward zero or that they continue to erode everyone’s alpha?
My view has been that as more and more capital chases market and factor neutral strategies, theifcreturns will trend toward zero. Any comment?
More the former. Think it's more pod on pod violence, folks who are not pods are not really playing for the same alpha opty's b/c their time horizon or mandate is different
Hi all, OP here - just want to say I greatly appreciate everyone’s responses (kind or not) and learned a lot from them. At the end of the day, I’m just a student trying to learn all I can and feel comfortable looking stupid if necessary.
I was curious if the ease and rise of indexing might be a headwind for it as a LT career path, because inherently investing seems to require some kind of edge. I appreciate the expertise and perspective!
I am an older person on this board, am an LP and I see everyone's track records (it's my job and I'm not special by any means).
Your question was neither stupid nor meaningless. Most hedge funds do not meet their stated objectives (the real objective is for the founder to get PAID) and it is down to idiot LPs like myself and our governance structures (and desires to not lose our stable well-paying jobs) that we agree to egregious liquidity terms and keep paying people to criminally underperform whatever the benchmark is, rather than redeeming. The stories I can tell you...
Most hedge funds do not survive 5 years (it could be less, I forget the stats the friendly prime brokers send out) and so yes, a long term career in HFs is indeed tough to build. For every person who makes a 10-30 year career out of it, there are countless others like me who quit/get fired/get spit out etc and leave the industry.
As to some of the replies to this thread (and in so many others), SMH. I won't say anything more.
In the early 1990s, hedge funds generated around 10% alpha with an industry size of $300 billion. Today, the industry has grown to approximately $5 trillion, but the average fund returns -1% alpha. The pool of available alpha hasn't increased proportionally with the industry's growth. Initially, there might have been a $30 billion pool (10% of $300 billion), but this pool has grown at a much lower rate compared to the assets. As a result, each fund might structurally earn lower percentage alpha, assuming alpha is a finite resource tied to certain factors.
Investors often can't predict whether a hedge fund's performance will persist. Early performance is extrapolated, even though it's easier to outperform with low AUM. Historical returns since inception aren't weighted by AUM, leading to potentially misleading figures. Despite this uncertainty, people invest in hedge funds due to human nature—similar to why people become entrepreneurs or try challenging endeavors. There's a tendency to take risks even when failure is likely.
Humans will invest in entire categories that never produce positive returns. If you are a hedge fund investor in theory its your job to figure these cases out. In a recent presentation by Paulson and Company they did an excellent analysis of why this is the case for the gold mining industry. Gold miners have not created shareholder value in the last couple of decades despite the rising value of gold. This is similar to how hedge funds have not created value despite an attractive stock market. Investing in gold mines involves taking current money with the promise of future returns, while executives profit regardless of outcomes. Similarly, past performance of gold mines may not indicate future results due to discontinuous events, mirroring hedge fund performance.
Hedge funds do not provide meaningful diversification relative to lower priced alternatives. They are highly correlated with the S&P 500 and one another. They have almost a perfect correlation with the S&P 500. But if they do not have performance in a dollar sense, they have performance in the theatric kind. Helping people retire is one of the most important things we do as a society, so those that manage our pensions need to make it look like they are trying their hardest. And it turns out that investing in hedge funds helps people feel safe. This is the product that hedge funds provide. For Bill Ackman, it's honestly just his face. He's just a smart, gray fox that comes across like a genius. That is what he is selling. He is also incredibly talented. I don't think he'll outperform all that much, but it definitely makes sense to invest even if he doesn't.
Still though the diversification argument misses the point. Sure, perhaps it might make sense to offer diversification and a higher sharpe if you're a super large pension. Makes sense. It's why they might invest in bonds. Sure, they are probably overpaying a bit but ok. But why do these funds all underperform the market year after year? Why is it not possible to outperform and offer diversification?
So why has the amount of hedge fund alpha been declining to the point where it is now negative? That's honestly so hard to believe. Why can we have negative alpha? I honestly struggle to understand how real humans in finance exist and are not more self critical. How does negative alpha exist as an industry? I thought alpha was zero sum and that there are some real dummies out there that hedge funds should be taking money from overall so if anything you'd expect industry PnL to reach an equilibrium percentage slightly above zero. Why is it so consistently below zero?
One theory that comes close to the right answer in my view but still misses the market is the one put forward by Michael Mauboussin. Michael Mauboussin's theory suggests that as a game becomes more skillful, remaining outcomes may appear luck-driven. Basically, once you have a near-perfect model, the residual is just noise which is luck. Mauboussin's clients are hedge funds, so it makes sense he would say this. The problem with this view is that it doesn't explain why alpha is negative not just for some managers but for nearly all of them.
Here is my explanation for the phenomenon:
Your word-to-thought ratio is ridiculously high
Your performance is prolly mid.
Def a new one: HFs should exist because it makes us feel better to have people "working" for our retirement savings / endowments?
I feel so much safer that our allocator, who gets overpaid, picked some FoF guys, who are overpaid and charge 1/10, to pick some HFs, that are overpaid and charge 2/20. Mind you, they are all useless since all the returns were correlated and they basically just exist as a superficial circle-jerk, and the retirement savings bought all these middle men houses in Greenwich, BUT thank god we have some overpaid people who look smart - really puts my mind to ease.
I actually don't disagree entirely... although some funds have certaintly delivered idio returns consistently, while others have outperformed on an absolute SI basis (depends on time frame I suppose).
Ultimately I kind of don't care either way; its fun work, and you can get rich trying to turn $1 into $2. Sounds good to me
Suppose there's whatever like $50T in equities in the US and $5T in equity HFs in the US and lets say there is ~1% annualized alpha available each year on the $50T, so $500B. In theory this is on the order of $500B of alpha dollars should be distributed evenly across the $5T of HFs. This is an unimaginable large amount of alpha available - something like 10% of the AUM of hedge funds, which is more than enough for all of them to share nicely. We also know that there just has to be some "dumb money" that donates alpha on some basis or that the amount of mis-pricing in markets is just larger than this.
Some of this seeming paradox is resolved by the fact that they do earn a small amount of alpha, but this is taken up by fees which act as leakage from the system. In a case where the market returns 10% a year, this ends up being 4% of AUM. This means that, collectively, on a gross basis, they might actually capture 200 bps of alpha. But still I don't think this is a good explanation. This doesn't take into account survivorship bias. They also probably pay borrow costs on shorts, but I don't think that makes up for the difference. Most likely as a group there is just no alpha even on a gross basis. I think if you added up all the hedge funds as a whole and take into account all the fees that are being paid etc you will still get to the conclusion that they net donate a massive amount of alpha to some other group. I don't think these "top funds" capture all the underperformance of "bad funds."
But where is this alpha coming from and going to? Based on the common theory, you should be able to add up the gross alpha across all the hedge funds in the world and they should net out to be closer to zero. Not sure how much Global Equities manages at Citadel, but say its $10B and say that all these other top funds that consistently outperform add up to $100B in AUM and so with 5-10% of annual alpha that's something like $5-10B. There's plenty of small funds that outperform, but in a dollar basis they don't contribute much and so they don't answer the question of why our alpha balance sheet doesn't balance. In the long run the "best" funds have modest performance and I don't think it adds up to anywhere close to the amount it needs to.
So the question is where is the rest of the dollars of alpha going? I don't understand how it is possible to do math that concludes that it goes from some hedge funds to other hedge funds that also take outside money. It must go somewhere else. The total underperformance is large enough that it cannot simply be transaction fees, crossing the bid/ask spread, etc.
A much easier set of math to do is to just say that there were a bunch of people with $10M 20 years ago that actually do earn 40% a year and that there's maybe 30 folks that have done this and built a moat through technology around it as a moat. Lets say there's 30 funds the sized approximately as big as Medallion that each manage $10B and earn 50% a year. In this case, that's $150B in total alpha dollars that are captured per year. Most industries seem to converge on an oligopoly over time and in cases where segments in industries are perfectly competitive they earn no economic profit. In economics class, I did not learn a theory that said that going to HBS or starting your career at a super hardcore place like GS TMT means that this rule of economics does not apply. Why would this industry be any different?
Even if you do believe in elitism, it seems likely that in an industry with 10s of thousands of people there must be some that figured it out. My point is that, if these people exist, they have little to no incentive to ever raise outside money in the long run. At best, it is a temporary thing. If you take Citadel as an example, you have to believe that they consistently do well because they have a moat that comes through their infrastructure they've built over the years and methodology for handling risk. If you believe that, then why is it difficult to then believe that there might be others that also built an enduring moat over time but decided to just not raise outside funds? With Citadel, it is in some sense interesting that they don't return investor funds and just use their own money. But I suspect they do this for reasons they don't disclose to the public. It's not good for marketing to say "We keep our best strategies to ourselves." My understanding is that they do have proprietary trading businesses that likely benefit from shared infrastructure and are successful today because they were subsidized by other more public-facing businesses like Global Equities. If I am not mistaken, most of Citadel's PnL as a business is not from Global Equities, as successful as it is. It is from their commodities business, which I think mostly is using their own capital, which illustrates my point.
This is not saying that hedge funds are entirely useless. My own belief is that they are kind of a "bottom b*tch" to use a technical term. If you can't do better than the market you can at least deliver an alternative product that you can't believe it's not butter. In other words, you can reduce drawdowns or reduce correlation but give up alpha in the process. In doing so, a prop fund should be able to capture this alpha and you get to create a nice ecosystem as a result. So, hedge funds do contribute something - some pension funds want this product - but in doing so they give away the good stuff to another party that probably just has them beat.
There are some that I do think primarily exist for a quasi-religious or faith-based reason. Baupost would be an example. We need to give money to Baupost in case of a day of judgement from Mr. Market. Seth Klarman is kind of like Moses and for awhile he was able to show the works of Mr. Market through miracles of outperformance. But maybe he has stumbled a bit through sin so I guess he's not as divinely inspired anymore. In this sort of worldview, Mr. Market tests us with temptations to sin with evils like multi-managers and retail investors. The greatest sin is the pride involved in short-term trading - of asking him to reveal himself rather than committing to faith. Importantly, like with the deity in the Old Testament, Mr. Market works in mysterious ways and so you're not supposed to question him and you're supposed to wait until your day of judgment when the Final Day of Catalyst occurs. I do think this faith-based reason is an important reason why the hedge fund industry continues to exist. We've tamed a lot of uncertainty in life and so we don't do rain dances or throw virgins into volcanoes anymore. But we do analogous things in the finance world. The alternative worldviews of firms that generate alpha like Medallion just simply don't survive in a mimetic competition for ideas - some of these are discussed in the biography of Simons. The only major work is the writings of Victor Niederhoffer imo, but these are not popular. If you ask for a divine being to show his good works and for proof immediately, then the beliefs become subject to scrutiny so these ideas do not survive as easily. You're likely to be disappointed and realize it is not real. This is why the vast majority of the word count of many major religious texts discuss the importance of faith in the face of contrary evidence. Similarly, notice how much of the religious texts of investing deal are apologetics for their own version of the problem of evil - why bad things happen to good managers. The sorts of classic beliefs of investing have survived largely because they have mimetic features that help insulate them and their proponents from disproof. But in doing so, they allow for a lot of profit for a certain group that has a different set of preferences than those involved with this faith.
I genuinely would like to be proven wrong here. Either there is actually an unimaginably small amount of alpha (in which case you have to believe in near-perfect market efficiency to an extent that seems utterly implausible) or you need to believe that actually its the case that there's a small group of hedge funds raising outside money that actually add up to a lot more than what I'm calculating (which also seems implausible) or you need to believe that RenTech is actually just the only exception (which also seems implausible).
No, but anyone seriously asking this question is.
There's a couple thousand hedge funds in the world, and it's undeniably true that **most** of them not only underperform the market after fees; but are also not actually uncorrelated or any less risky.
Everybody here just retorts "but that's not true for the top MM funds!!! The top funds have proven track records!!!" and maybe so, but those top funds are usually closed to new investors, so you can't get in anyway.
Individual funds may have an "uncorrelated" return stream, but allocators never have an allocation to just one fund or just a couple. You'd risk your career as fund performance is rarely consistently top percentile, and you need to spread your risk
If you've seen a portfolio of hedge funds, you'd know that the resulting portfolio is VERY correlated to the market, essentially paying for market beta
God forbid you pick the wrong funds, and your overall performance is also terrible
Hi, PM here. At some level they are absolutely useless generally because the incentives can be misaligned. The fee structures are such that there is often a premium placed on the up years (many take larger than advised risks to get these) and then hold through/don’t cut losses when things move against them and the LPs suffer because the fees from the up years are already locked in. Most if not all crystallize carry at end of year so even if a fund goes up in the first year but down to literally 0 in the next few, they can still hold/charge carry from the first year.
further, a lot of funds just are levered beta which again is bad for the LP. Finally, a lot of them share all of their ideas to the point where you might be over exposed to certain sectors through a collection of funds and not even realize it.
however, in a bad year it can be huge for an allocator to have one green blip of a hedge fund that returned positive and this is very valuable to most people.
open to pushback on this, curious to see what rest of community thinks
Hey you sound smart - had a question. I understand the levered beta argument and how it’s generally not something you should be paying for - however what if you were consistently right on certain themes like tech bubble, housing crisis, A.I, long commodities in 2020/2021, why shouldn’t you pay for these betas ?
Anyone can explain ?
In the grand scheme of things maybe less than 1% of the funds is useful, and people like to convince themselves they are the 1%.
As a decision maker, you need to at least ~15 years to prove your “stock picking skills” is not pure luck, whether that’s beating market returns AFTER FEES or hedging against downturns, and by year 15 your strategy is likely already outdated. So it just becomes a sales game in the end, where you have to convince your investor your 5 years track record of investing is not luck or that your strategy for the past 15 years will continue to work.
The good thing is you can still always make money off of it because ultra rich people will always prefer something that the peasants can’t access to.
Basically, yes. Any HF not named Citadel or Millennium is useless.
Anyone at those firms not named Ken G or Izzy E, is useless.
The special sauce is not the PMs/Analysts. The special sauce is the furnace that burns those peoples’ hopes and dreams as a fuel source.
Every other HF is a fraud. Either taking on excessive risk with an inevitable mean reversion (eg Melvin) or remarkably subpar performance that is aggressively marketed until LP/allocators finally have to answer for what the fuck they’re actually doing.
Quia modi error quaerat error quaerat dignissimos. Ut aspernatur quaerat distinctio sapiente. Delectus distinctio quia fugiat molestias. Quas rem id omnis id. Accusamus quia deleniti vel vel architecto quibusdam qui nulla.
Non explicabo voluptas aut accusantium molestias placeat ea. Non nihil et soluta. Voluptatem quia unde earum quia ut mollitia.
Officia est ea excepturi repellat et laboriosam quia repellendus. Necessitatibus magnam non consectetur et quis atque ducimus. Ut ut impedit aliquid explicabo. Quos dolores sint modi autem nostrum. Magnam in dolorem nihil consequatur non esse consequatur dignissimos. Hic tempora ad velit. Animi nesciunt omnis repellat quis quidem.
See All Comments - 100% Free
WSO depends on everyone being able to pitch in when they know something. Unlock with your email and get bonus: 6 financial modeling lessons free ($199 value)
or Unlock with your social account...
Quibusdam quidem pariatur voluptas amet molestiae dolorem. Non et sed beatae sint. Est est provident corporis ab. Sed sed veritatis officia iusto praesentium.
Molestias nemo est sapiente at. Vero voluptas sit vel harum eos maiores optio. Voluptatibus et non placeat tenetur.
Illo maxime aperiam sint ut officia quod. Fugit earum et qui tempora ut at ipsam. Harum blanditiis quia excepturi eligendi dolor. Ad nihil praesentium at sunt eligendi.
Dicta natus dolorem hic facere officia voluptatem. Excepturi voluptate maiores dolores ratione amet incidunt. Non dolor quas quia quia. Harum ab recusandae vel. Quo incidunt vero et voluptatem ab distinctio a.
Omnis odio adipisci iusto sunt voluptates est perferendis. Repellat molestias error dolores architecto.
Nobis nemo hic et provident. Libero voluptatum adipisci et voluptatem.