Comments (54)

  • Analyst 3+ in HF - EquityHedge
1mo 

Diversification, paying for alpha, uncorrelated returns etc. An average hedge fund is a bit of a misnomer, its a field that rewards the top x%. Look at the podshops like Citadel and Point72 being up significantly on the year whilst indices are down.

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1mo 
curiousandcurious22, what's your opinion? Comment below:

I get the arguments for the top ones. But what about the 90%+ that are shit? There are like 27k hedge funds in the world. I can only see a legitimate argument for investing in like 1% of them; the rest, I'd just stick to VOO or QQQ

1mo 
nutmegger189, what's your opinion? Comment below:

Try telling a pension fund to stick their money in QQQ and they'll die of shock.

Some institutions want alpha. What is alpha? Alpha is returns excluding beta. What is beta? In simple terms, exposure to the market. What is QQQ? A levered market etf i.e. levered beta. Literally the opposite of what the institutions want.

Ask yourself. Why do people invest in bonds? Real estate? All of these above underperformed the S&P. Ask yourself why do people not invest all their money in PE when it outperforms the S&P? The answer to these questions is the same.

  • Prospect in AM - Equities
1mo 

I don't get you people. I really do not. Do you lack IQ or the ability to think independently? The market is a competition. No shit. An equivalent question would be, what is the average finish of a runner in a marathon? The average has no significance in a competitive environment.

1mo 
curiousandcurious22, what's your opinion? Comment below:

Lol? There are like 27k hedge funds in the world and less than 1% of them beat the market. 

Warren Buffett literally said hedge funds are shams since the top "investment pros" (even the top hedge funds) can't beat the market on average. He advocates for investing in index funds. So unless you know more than Warren Buffett, sit tf down prospect in AM.

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  • Prospect in AM - Equities
1mo 

You're a fool for believing that statistic. It just further proves you cannot think independently.

  • 2
1mo 
FinancelsWacc, what's your opinion? Comment below:

The average does matter in this conversation...

Using your example, the analogous situation would be Nike sponsoring the average Joe Schmo running his first NYC marathon instead of Kipchoge. They don't... so why do the bottom 99% of hedge funds receive capital? It's a very valid question and asking the question is a very logical way to learn (and more efficient than studying all the fundamentals to come to the conclusion independently).

  • Consultant in Consulting
1mo 

The SP500 is not the correct thing to benchmark a market neutral hedge fund to. (Most) hedge funds claim to be market neutral therefore their returns are not supposed to beat out to market. They're supposed to not be correlated to the market at all so it would technically be the opposite

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1mo 
HFPM, what's your opinion? Comment below:

How am I the 10th person to reply to this thread, yet the first to mention Risk (the other side of the reward calculation)? Trying looking at proper metrics which incorporate both.

Secondly, you're looking at 10 of the greatest years in history to be levered long beta because of the immense liquidity in markets post gfc. 
 

third, it's absolutely true that many of what people call hedge funds are not that. They're levered long-leaning beta plus essentially portable alpha. 

  • Investment Manager in HF - Other
1mo 

This has already been mentioned by others:

1) that isn't a very representative time period   It is easy to backwards looking pick a beta return stream that did well (just lever bonds starting in the 70/80's and you are golden).
2) averages are a bad measure for hedge funds for many reasons, including that you aren't necessarily even comparing the same asset class (would you compare a fixed income hedge fund to the s&p? What about global macro?). Then you also have the fact that there are definitely bad hedge funds and that some hedge fund have specific vol and return targets, they aren't targeting the s&p
3) you aren't taking into account the risk (including drawdowns, etc)  

4) yes, there are bad hedge funds 

Most Helpful
1mo 
mtnmaster1, what's your opinion? Comment below:

Other people are saying this but to clarify. If you manage $10bn for a pension fund or for a university endowment, your goal is to meet funding needs in +20 years and grow that money at a solid rate. You cannot lose that money because it is needed / already promised for various uses. Think about how to diversify that money and generate strong compound returns over decades without taking too much risk that you will fall short of funding needs (remember how much volatility and down years hurt your long term performance). 

True hedge funds deliver returns/alpha within very specific risk/return parameters, which is very valuable for these clients. If you know citadel can make you 10%-20% per year in equities no matter what happens in the broader markets, that is very very attractive, especially if most of it is alpha. Then you have some managers who you pick because they tend to generate amazing returns in strong bull markets by picking the winners throughout that period (and are supposed to be hedging out risk to the downside...) like the tiger cubs. Or you have a niche biotech doctor guy who you give a smaller allocation to capitalize on healthcare trends. Or you have a macro guy just trying to beat the bond yields (which for the last decade gave you nothing). A macro fund is not looking to beat SP500 so that is a very poor benchmark. 

There are a variety of funds/strategies that all fulfill various investment needs for these institutional investors, and that is how you get so many. 


At the end of the day, there are tons of funds that offer subpar returns with little differentiation because the incentive structure of the vehicle is attractive for the founder, but those tend to not last very long. Looking at averages for hedge funds vs. SP500 is useless, but the largest and most successful funds tend to offer that attractive alpha + risk/return setup against their designated benchmark. Then at the end you are left with a handful that are special and just trying to deliver absolute returns but may not have great sharpes/alpha generation, but those guys have been around for 30 years and the reputation + absolute returns + client relationships have been good enough over a long enough period of time that they stay in business. 

  • Principal in RE - Comm
1mo 

Because how else are you supposed to justify your pension fund manager position by investing in the S&P? 

1mo 
ke18sb, what's your opinion? Comment below:

What no ones seems to have said yet is the term hedge fund is extremely extremely broad. There are so many different types of hedge fund strategies. You can split it up by asset class, so credit, equities, commodities and derivatives, etc...then by type so long/short, neutral, opportunistic, value, technical, distressed, etc...they by size so large cap, small cap...then by sector so generalist, industry specialization... then by geography, so US, Europe, Asia, etc...then by use of leverage....list can go on and on. 

Point is its meaningless to use an aggregate stat about hedge funds without really diving into a specific subsector. 

As for why someone would invest in a hedge fund, its ideally because the returns are going to be less correlated from the overall market and its a means of diversification. 

  • Associate 1 in RE - Comm
1mo 

This post is so dumb. Yeah sure, maybe the run of the mill $500mm aum l/s fund is a bad investment over the long run for an endowment or pension, but why do you lump in all other strategies? Do you know what the benchmark is for a cta fund that only invests in rates and commodities? What about a tail risk fund that straddles atm vol to pay for insurance? I can assure you it isn't the s&p500. The notion that all "hedge funds" bench the s&p500 is so naive that it shows you don't understand public market investment funds as well as your comments suggest.

1mo 
herzyherzy, what's your opinion? Comment below:

Two already really good posts on here regarding both 1) risk management and 2) allocator preference by @HFPM and @mtnmaster1. Think the only thing I have to add is historical context that was alluded to in an early reply. 

When markets aren't going up and to the right constantly and we've experienced a low-rate environment, you see a multitude of things happen. Levered beta outperforms as markets go up at low risk (risk-free at/near 0%). It's why private equity has done extraordinarily well. Rates dictate valuation broadly across markets as people care about cost of capital. People care about cost of capital because of shareholder returns and free cash flow generation. And people care about free cash flow generation because in a margin of safety exercise cash flow is all that matters. When debt is free, any investment that relies on leverage becomes a good one, especially when valuations have room to run if rates are staying stagnant at low levels as both WACC is solidified or fixed at a lower level and margins can grow as a result (typically, not always).

I think the real issue in the long/short world is that for years the SM industry has become ultra-sector focused in a result of believing they could identify alpha in idiosyncratic ways, when actually the rise of ETF-based investing, indexing, and factor-trading algos have moved all stocks of a similar vein in highly correlated directions. Was there a material difference in owning software co A and software co B over a 5-year time horizon from 2014-2019? Probably not much. Citadel exists to exploit the very alpha capture that exists on earnings and within the early weeks of a trade, with all market risk hedged out. Large allocators love consistent returns with little risk, and from a procedural perspective they likely repeatability. If Citadel can generate 15% in an up 20-25% year but also generate 10-15% in a down 15% year, a risk-averse allocator will take that bet every time. 

To the note on the Q's. The market is down ~16% as of writing this and the Q's are down 28% YTD. If you're a pension with fairly strict risk parameters, the exercise in investing in a 2x levered market ETF at no cost is exactly that. The bottom line and people forget this is: if you compound at 20% a year for 5 years, but then lose 60% of that in any given period of time, you're still losing 60% of whatever you generated in those 5 years. People tend to forget that % gains are not perfectly convex on both sides of a PnL.

  • Associate 2 in ER
1mo 

Its a product and basically outsources the stock selection part of the job. Imagine you run a $20bn endowment and being the smart CIO you are, you see an opportunity and want to overweight small cap gold miners. You want to start a small position of 3%, $600mn. You don't have the manpower, expertise, or liquidity to invest $600mn small cap gold miners. So you decide to allocate to a small cap gold mining fund. This fund probably underperforms the S&P 9/10 (especially past 10 years of zero interest rates), but they handle the stock selection, liquidity, all that, while you focus on portfolio management. HF are selling a product and 99/100 that product isn't absolute returns. If it was, you would see a lot more funds outperforming index.   

Also indexes are inherently underperformers. Your money is invested in stocks that have already gone up enough to now be included in an index (price now reflects what market was missing). And sells once stocks have gone down enough to be excluded from an index, (market is currently pricing in downside risk). front-running index inclusion anouncements and then that index's forced buying/selling is free money. 

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1mo 
HFPM, what's your opinion? Comment below:
 

Also indexes are inherently underperformers. Your money is invested in stocks that have already gone up enough to now be included in an index (price now reflects what market was missing). And sells once stocks have gone down enough to be excluded from an index, (market is currently pricing in downside risk). front-running index inclusion anouncements and then that index's forced buying/selling is free money. 

I really wish I could post some sort of "WTF??!?!?" GIF 

  • PM in HF - Other
1mo 

OP's clearly new to this and their analysis is lacking, but the data is compelling and everyone is looking past it, so I am going to step in with an assist.

To all of the people making arguments like: HFs add diversification, you have to look at the returns risk adjusted, HFs make money off less informed players, etc. Paste those two returns series into excel. Run CORREL, it is 0.91.

The information ratio for that hedge fund index vs. the S&P over this period is negative. After adjusting for beta, the aggregate of the industry did not beat fees over the decade, i.e. had negative alpha. In other words, if you could "short" the hedge fund index (over this time period), it would be more sharpe ratio additive to a S&P 500 portfolio than being long the HF index (if you are unfamiliar with portfolio math and don't believe me, just try different weights on the returns series above and calculate the sharpe on the combined series. You will find a negative weight on the HF series results in a higher sharpe ratio than a positive weight). 

I think some important observations are: 

  • When you are holding a portfolio of hedge funds, a lot of those managers are going to be net long (and sometimes sneak in beta in ways that is hard to catch) so you are going to end up paying exorbitant fees for beta, and when you average this is mostly what you see. The beta also hides underperformers (until of course, when they blow up). 
  • A lot of hedge fund managers claim the industry makes money trading against less informed players (passive, retail, institutions, mutual funds, market makers). At least over the last decade, the sum total made trading against these players were less than hedge fund fees, and the rest was zero sum between hedge funds, so manager selection / access / timing is almost everything

If I were on the other side as an allocator looking at this data, I would: 

  • Demand stricter risk requirements, favoring neutrality to the market and easily replicable factors  
  • Add pressure for HF fees to go down, until there is evidence of outlier performance (in which case the fund will probably be closed anyways)  
  • Secularly cut some risk from the "alpha" part of my portfolio 

Good reasons to invest in hedge funds are when you have edge in picking the best managers (or getting access to them), when you can identify promising managers early and secure good terms, or when you are good at timing in & out of trendy strategies --> and you should know you are playing in a zero sum game against other allocators. To answer the question: Why do people invest in hedge funds? They think they are good at all of these things, but the reality is the average allocator is not and ex post shouldn't be invested in hedge funds. 

Obviously this is just a sample of 10 years, but in some ways the most important 10 years as it is the most recent. In my opinion, the days where you can hold any portfolio of brand name hedge funds and accrue value while they trade against other uninformed players in diversifying ways are over. 

    1mo 
    HFPM, what's your opinion? Comment below:

    Many good points in here.

    I'm going to wonder about the applicability if the analysis were not run against the average hedge fund (which includes a MASSIVE long tail) and instead was size-weighted or only included the 100 or 200 largest funds in the world (which by definition should account for some of the caveats you mention - size should correlate with quality of manager broadly).  
     

    Also to be fair we still haven't discussed risk. What if the vol of the average hedge fund in that return stream were half the spx? Then you could apply leverage, replace spx with the correlated return stream, and for the same risk, have better return expectations. 
     

    this whole debate is flawed because we are not starting from a reasonable framework for answering the questions.  

    if someone really had the time and energy (I do not), they could spend an hour or two gathering real data and making a compelling case for why hedge funds (when chosen carefully) are additive to a portfolio. 

    • PM in HF - Other
    1mo 

    Not to be pedantic but the information ratio does incorporate an answer to the risk question, I think it is a good framework for evaluating whether a strategy is additive to an existing investment option like the S&P 500 (and with a negative information ratio the risk point becomes kind of moot, similar to a negative sharpe ratio).

    Agree on size though most BarclayHedge indices are AUM weighted (not sure if this was a special one that was even weighted but yes that would be dumb)

    Also agree that correlation on 10 data points is tiny sample and deciding whether this is just random noise or real is more art than science (and why I said "in my opinion"…). But it's all we have, if you showed me positive hedge fund information ratios from 1990-2005 I would say that tells you very little about how HFs will do 2020-30.
     

    Can take another look if I have time over the holidays, but when I looked into this a couple years ago, historically these indices have had strong information ratios, and then went flat to negative in the last decade (in my eyes the result of less informed active players leaving the market for passive investments, i.e. the fish are trading less and only the sharks are left fighting for P&L)

    • Investment Manager in HF - Other
    1mo 

    OP's clearly new to this and their analysis is lacking, but the data is compelling and everyone is looking past it, so I am going to step in with an assist.

    To all of the people making arguments like: HFs add diversification, you have to look at the returns risk adjusted, HFs make money off less informed players, etc. Paste those two returns series into excel. Run CORREL, it is 0.91.

    The information ratio for that hedge fund index vs. the S&P over this period is negative. After adjusting for beta, the aggregate of the industry did not beat fees over the decade, i.e. had negative alpha. In other words, if you could "short" the hedge fund index (over this time period), it would be more sharpe ratio additive to a S&P 500 portfolio than being long the HF index (if you are unfamiliar with portfolio math and don't believe me, just try different weights on the returns series above and calculate the sharpe on the combined series. You will find a negative weight on the HF series results in a higher sharpe ratio than a positive weight). 

    I think some important observations are: 

    • When you are holding a portfolio of hedge funds, a lot of those managers are going to be net long (and sometimes sneak in beta in ways that is hard to catch) so you are going to end up paying exorbitant fees for beta, and when you average this is mostly what you see. The beta also hides underperformers (until of course, when they blow up). 
    • A lot of hedge fund managers claim the industry makes money trading against less informed players (passive, retail, institutions, mutual funds, market makers). At least over the last decade, the sum total made trading against these players were less than hedge fund fees, and the rest was zero sum between hedge funds, so manager selection / access / timing is almost everything

    If I were on the other side as an allocator looking at this data, I would: 

    • Demand stricter risk requirements, favoring neutrality to the market and easily replicable factors  
    • Add pressure for HF fees to go down, until there is evidence of outlier performance (in which case the fund will probably be closed anyways)  
    • Secularly cut some risk from the "alpha" part of my portfolio 

    Good reasons to invest in hedge funds are when you have edge in picking the best managers (or getting access to them), when you can identify promising managers early and secure good terms, or when you are good at timing in & out of trendy strategies --> and you should know you are playing in a zero sum game against other allocators. To answer the question: Why do people invest in hedge funds? They think they are good at all of these things, but the reality is the average allocator is not and ex post shouldn't be invested in hedge funds. 

    Obviously this is just a sample of 10 years, but in some ways the most important 10 years as it is the most recent. In my opinion, the days where you can hold any portfolio of brand name hedge funds and accrue value while they trade against other uninformed players in diversifying ways are over. 

      The correlation of annual return streams over a 10 year period is essentiallly meaningless. While you have to pick a time period, arbitrarily having the 12 months of Jan - Dec doesn't mean much, especially for places that require monthly liquidity (think if march/April 2020, markets ended up fine for the year, but are you ok with that big of a drawdown?). Also you want high correlations to something that goes up in a straight line (roughly what happened to equity markets), being negatively correlated wouldn't be great here.

      Also, I wouldn't say the last 10 years are arguably the most important (especially when you exclude 2022). As an investor you want to look forward, if your sample doesn't include any real bear markets or shocks, etc then how are you confident things will work going forward? It's similar to being an investor who is always long value and have only lived in periods when value stocks outperform, you don't know what will happen if value underpforms, so you want to make sure you believe that what they have done will work going foreward and most people don't think the last 10 years are indicative of how US equities will perform for the next 10. 

      1mo 
      Smoke Frog, what's your opinion? Comment below:

      I think rich or novice investors allocate resources to hedge funds to get access to as exclusive investments, exposure to idiosyncratic investing methodologies and because index investing can be a slow and steady process.

      Many of my father and father in laws friends invest a lot on private money managers or alternative investments. And I used to argue with them about the virtues of vanguard. At one dinner, a money manager told me the above reasons.

      He said you would be shocked how many people kind of know index investing is superior but enjoy moving money from hedge fund to hedge fund and looking for that next home run.

      • Investment Manager in HF - Other
      1mo 
      Smoke Frog

      I think rich or novice investors allocate resources to hedge funds to get access to as exclusive investments, exposure to idiosyncratic investing methodologies and because index investing can be a slow and steady process.

      Many of my father and father in laws friends invest a lot on private money managers or alternative investments. And I used to argue with them about the virtues of vanguard. At one dinner, a money manager told me the above reasons.

      He said you would be shocked how many people kind of know index investing is superior but enjoy moving money from hedge fund to hedge fund and looking for that next home run.

      Most of the big money comes from institutions, not individual investors. By the numbers, lots of those small hedge funds will try and get AUM from many individuals, but by dollar amount at the large places, it is institutional money (some don't even allow individual investors). 

      • Analyst 2 in IB - Cov
      1mo 

      There isn't one unless you want exposure to commodities or something niche. The rest of this thread is just people justifying their own fees, which aren't worth the beta they chase

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      • Analyst 2 in IB - Cov
      1mo 

      It says I read the recently posted thread u boomer

      1mo 
      lecpmoc, what's your opinion? Comment below:

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      • Intern in ER
      1mo 

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