Please help me understand this about HFs

I'm five hedge fund types (arbitrarily chosen, and clearly not the entire population) into a data project on HF RORs, and I'm already struggling to understand how the HF industry still exists. Here's a screenshot of some of the numbers I'm looking at (please note that I understand these numbers may be off by a few percentage points here and there, but I think the numbers are not far from the truth, whatever that is).

Edit: Try and keep in mind the overarching theme here (no fund indices outperforming the market), not the specifics of my approach, unless that is so important it makes this whole post useless.

Sources: 1, 2, 3, ILF = iShares Latin America 40 ETF

I'm going to keep searching for niche HF types that are doing well, but this was just depressing to me. As I've been crunching the numbers, a lot of the active management arguments I'm familiar with have become much less convincing to me. The only one I can think of that still holds some weight is that HFs do much better in downturns, but that makes me wonder, if you were planning on putting your money in right as the trough in the economic cycle begins (assuming you have a crystal ball and know when the inflection point is), why would you not just withdraw from the market entirely? Although all of the HF indices I've looked at experienced much less negative ROR during the Great Recession, all of them still lost money as a whole. In the case of pension funds or insurance companies that need to make consistent payouts, why not just self-hedge (and maybe they partially do this, I don't know) by not investing two or three standard deviations worth of the expected payout amount, and then invest the rest in (insert index of choice here)? Seems like they would still beat HF returns in the long run.

Do all hedgies just think they can be the special snowflake that happens to kill it? Please help me understand how the HF industry still exists. I think there's no question with the amount of information asymmetry in the 90s that HFs were a novel and profitable idea, but nowadays it seems like it doesn't make sense anymore. I recognize there at least hundreds of billions under management in HFs, so obviously people know something I don't, and I want to learn whatever that is. I'm enamored by the the way Macro Bruin and others have described HFs as "a small, niche industry of the most talented minds in finance," and would love to believe that's true and that it's a profitable service and public good. Is it just like Macro Bruin says, that we need to significantly reduce the quantity of HFs, and the investment vehicle will be resurrected? I want to keep the dream alive! Thanks to any and all responses.

-Treeman

[Disclaimer: I understand I'm a naive student, and I know this gets discussed a lot on here, but looking at the actual numbers brought up some new questions for me.]

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Comments (27)

Nov 11, 2017 - 5:03pm

This isn't hedge fund specific,, but more active versus passive.

One thing that isn't noted in the debate of passive versus active is the possibility that active boost returns overall for the market. Active is a bit like a professor giving out company grades for their performance. By doing this does it A) force companies to perform better b) meaningful chooses which companies overall get capital.

If everyone was passive who would choose who gets capital? Who would choose who is in the index? Who would pressure management to be shareholder friendly?

And while their is some fundamental reasoning that says active guys in net cant beat their index perhaps the process of creating the index is boosting the returns of the index (which passive gets a free ride on). My guess is we need a certain amount of active management to keep the system in place that allows passive vehicles to be successful.

Nov 11, 2017 - 5:38pm

Great comment. So, do you think it's possible to come up with a way for active trading to benefit the market and simultaneously beat it? What are the "fundamental reasons that say active guys can't beat their index"? Interested to hear.

Nov 12, 2017 - 7:12pm

Mathematically somewhat impossible. If mkt return is 8% then the sum performance of all active funds would be 8% minus fees. Unless there was some one who was a net loser in markets to allow the funds to outperform the market.

The true benefit of active management at this point is to push up the overall market return and not to beat the market return.

Bond funds have a loser class to make money off of. So bond funds can actually outperform (Central banks etc are not concerned with returns so they can lower returns while funds have higher')

Nov 12, 2017 - 5:11pm

What's the sharpe ratio of these funds? Risk adjusted returns?
Why are you comparing market neutral funds against the S&P 500 given the past 8 year long bull market?

Time range starting from 2008? Hahahaha.....

Great job comparing EM to the S&P 500 too. Awesome analysis.

Nov 12, 2017 - 10:38pm

SanityCheck thanks for the response. You point out some glaring holes I need to fix, so thanks for that. Do you have any thoughts on the big picture here? Being that you're at a HF I'd love to hear about your experience.

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Nov 14, 2017 - 7:44am

I agree that a lot of funds may not add much value, but I think it really depends on the strategy. A decent PM with a focused strategy can still add a lot of value to a large pension or endowment even if he can't beat a bull market.

With that said, I think fees do need to come down and/or change. ~50bps and 20% would be more competitive, as it really focuses on performance and not existing just to exist. Or just pay a flat $x million fee and the rest is all % equity on upside. The large $10b+ funds have an incentive to simply exist, and collecting 2% is a huge amount of cash.

Finally, markets are only efficient if there's enough people trying to beat the market. If everyone goes passive, by definition there won't be enough people trying to beat the market. That makes the market less efficient and we've already seen evidence of that (my biggest short in my PA is SNAP and HFs all saw the clear signs but long-onlys loved it) Not sure if it would be such a good idea without all the dumb money.

Nov 14, 2017 - 12:30pm

Hedge funds all saw the obviousness in snap?

I got no idea on it here. Don't think I"ve ever traded it;

But there were a few big dogs buying the ipo. I think tepper did though he may have sold highs and rebought

Nov 13, 2017 - 10:50am

That could be one explanation, although you'd also have to believe that a) the association of a particular fund with the top percentile group is persistent; and b) that investors are able to determine a priori which funds belong where. The evidence to suggest that the assertions above hold is mixed, at best.

But, at any rate, what I would recommend you do is at least peruse the available literature that offers some insights on the subject. For instance, this seems like it might be a worthwhile place to start:
https://www.cfapubs.org/doi/pdf/10.2470/rflr.v4.n2.1

Best Response
Nov 14, 2017 - 6:29pm

Hedge funds don't exist to 'beat the market'. Many of the biggest and most successful funds of the day are there not because they beat the market, but because the demonstrate other properties (e.g. limited volatility) that investors value.

Throwing up some returns and then complaining about lack of value add is meaningless. Unless you understood what the goal of each hedge fund was, you have no idea how they did. That is why all of these silly hedge fund indices that compare themselves to this or that market are ... silly.

2) No one invests in a specific hedge fund because of hte performance of hedge funds as an asset class, just like no one invests in a specific stock because of the performance of stocks as an asset class. Stocks can go up while your stock goes down, or vice versa, and its all about aht individual stock. Same goes for HFs. Obviously, the only reason anyone invests in single name (stocks or HFs) is because they think they can pick the right horse, and just because most people fail at this will not stop them from trying

  • 5
Nov 15, 2017 - 12:35am
dazedmonk:

Hedge funds don't exist to 'beat the market'. Many of the biggest and most successful funds of the day are there not because they beat the market, but because the demonstrate other properties (e.g. limited volatility) that investors value.

Yes and no. Their purpose is not to beat the market, but if the S&P is up 20% and a US Equity L/S fund is up 2%, their LPs will be absolutely furious. Of course to beat the market you generally need to take more risk, which goes against their reason for existing. Catch 22

Dec 9, 2017 - 11:50am

WTF ? This is just wrong.

Firstly, L/S funds are usually absolute return strategies, so their returns relative to the S&P are irrelevant. Yes, LPs would be furious if a L/S fund only generated 2% returns, but not because of its performance relative to the S&P, but because the 2/20 fee would eat any value that the manager was able to generate i.e. the LPs overpaid for the performance that they received. However, I'd add that a single year of tepid performance wouldn't be enough to make investors "absolutely furious". If the fund is averaging 7% returns with +-5% deviation, a 2% year is just a blip and wouldn't mean anything to LPs; those are solid numbers, especially in this environment.

This does all depend on the particular L/S strategy, as they aren't all structured the same, and they don't all take the same risks. At the end of the day, it depends on your market/beta exposures, if the strategy is market neutral, the LPs could always overlay a swap on top of the LS strategy to get the beta exposure that they desire: 2% L/S + 20% S&P - financing cost priced into the swap(LIBOR which is negligible).

Nov 15, 2017 - 9:39am

Thanks for the insightful response. You mention limited volatility as an attractive quality, what are some other properties HF investors value that lead them to put money in HFs rather than an ETF of equities or bonds or whatever else?

Nov 15, 2017 - 3:59pm

some view hedge funds as diversified equity positions. expected returns are higher than bonds but lower than public equities (which don't hedge). They limit downside (drawdown %) compared to equities, but as a trade-off they provide lower expected returns. As compared to bonds, they provide upside return potential but higher risk for loss of capital. This is important for institutions where big drawdowns are a problem, but they still want to earn higher expected returns than bonds.

Nov 15, 2017 - 6:12pm

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Nov 15, 2017 - 5:44pm

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