Overpayment for Underperformance: Hedge Funds Steadily Lose Ground

Dear Reader,

A fool and their money are soon parted.

The Financial Times on 22 May 2020:

Vlad Matveev has learned the hard way how volatile cryptocurrency hedge funds can be.

The 50-year-old Muscovite invested $250,000 last year with California-based Cryptolab Capital, which targeted double-digit gains from trading crypto regardless of whether the market rose or fell. But Matveev said his investment fell 98.5 percent in value when the fund folded in this year’s coronavirus-induced turmoil.

“I don’t really know what happened,” said Matveev, a fund manager-turned-private investor. “They said they had a diversified set of strategies.”

Fund manager turned private investor?

With that sort of investing IQ, future Russian investors have dodged a bullet with Vlad out of the game.

Didn’t know how volatile cryptos could be? Why would you admit to being this dumb in a national paper?

Vlad fell for the old ‘we’ll make you money in good and bad markets’ hedge fund spin.

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He obviously doesn’t read Bloomberg:

The Rum Rebellion

Source: Bloomberg

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As the byline states, hedge funds ‘neither outperform in bull markets nor offer insurance in bear retreats’.

And one final observation, Vlad believed the hedge fund had a diversified strategy? Earth to Vlad, the fund was only invested in cryptos.

Long story short, Vlad deserved to lose 98.5% of his money. That was a dumb investment.

And while it’s easy to sit back and poke holes in Vlad’s less than successful foray into hedge funds, he’s far from alone.

The allure of double-digit returns and having an inside running on markets with the smartest guys and gals in the room is the reason this regularly underperforming sector stays in business.

But the hard data is pretty conclusive. Most should shut up shop.

These are not trick questions.

If I could show you — 10–15 years in advance — how you can outperform 90% of investors, would you be interested?

And, as an added sweetener, if that outperformance cost you next to nothing to achieve, would you be doubly interested?

Not a bad deal? Yep, I agree.

In the interest of full disclosure, nothing in life comes for free.

In opting to outperform 90%, you will underperform the very fortunate 10 percenters. The ones whose portfolio will compound at a higher rate than most.

As a 90 percenter, you are bound (at some point) to experience 10-percenter envy.

These are the times when you learn that someone is doing better (sometimes, much better) than you. Managing that emotion is not easy. This is the old ‘bird in the hand or two in the bush’ conundrum.

In looking at the trends, it appears that more people are opting for the ‘bird in the hand’.

In October 2019, the Haas Business School at University of California produced a research paper titled ‘Active and Passive Investing’.

I found this chart interesting. Since 2008, Active Mutual Funds and Hedge Funds (the higher fee charging options) have steadily lost ground to the lower cost options…ETFs, Passive Funds and households investing directly in shares.

The Rum Rebellion

Source: Haas Business School

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People, in greater numbers, seemed to be coming around to Warren Buffett’s thinking (emphasis added):

A low-cost index fund is the most sensible equity investment for the great majority of investors…By periodically investing in an index fund, the know-nothing investor can actually out-perform most investment professionals.

Vlad should have taken note of this; ‘the know-nothing investor can actually out-perform most investment professionals’.

There’s plenty of data to back up the Oracle of Omaha’s blunt advice.

The S&P Dow Jones Indices publishes an annual report titled ‘SPIVA US Scoreboard’.

This table — on the percentage of US Equity Funds that failed to outperform the relevant benchmark — is from the year-end 2019 report…

The Rum Rebellion

Source: SPIVA

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The longer the timeframe, the more consistent the data becomes for each sector.

Almost nine out of every 10 active (higher fee charging) fund managers CANNOT beat the relevant benchmark (index) over a 15-year period.

The underperformance of hedge funds

If we look at the (consistent) underperformance of THE most expensive of active managers — hedge funds — you can see why that sector is shrinking…

The Rum Rebellion

Source: Market Insider

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As reported by Market Insider on 15 October 2019:

Since the start of the recovery in financial markets in 2009, hedge funds have perennially underperformed the S&P 500 index, as shown in the chart above.

In 2018, famed investor Warren Buffett took a victory lap after winning a bet that passively-managed funds could beat actively-managed hedge funds over a period of ten years.

Not only did Buffett’s wager turn out right, but he also took the opportunity to remind investors of the importance of management fees to overall investor returns.

Paying much more to receive much less is not a very clever way to invest.

Adding insult to injury, investors pay a 2% management fee PLUS if there’s a month when the fund does beat the benchmark, they get whacked a 20% outperformance fee…even though over the longer term the fund doesn’t beat the benchmark.

This excellent wealth creation strategy for the hedge fund manager and not so good result for the investor, was something I wrote about in my 2017 book How Much Bull Cam Investors Bear?

This is an edited extract:

Ignorance. Gullibility. Overconfidence. Greed. Fear.

All of these play a role in producing poor outcomes.

Knowing and accepting the contribution these factors make to investment failure is half the battle.

The other half is having a disciplined strategy to minimise the risk of falling off the wagon and being caught up in the social mood created by the next crisis or bubble.

And throughout the battle you have to understand industry spin.

The investment industry knows investor psychology better than anyone. Which is precisely why they design the products the way they do…with lots of promise.

The industry goes to great lengths to make investments sound “sexy and alluring” — using terms like “absolute return funds”, “tax effective”, “alternative investments”, “private equity”, “special opportunities” and so on.

Sexy sells. And in the investment business, the very highly-priced hedge funds are definitely portrayed as sexy.

Hedge funds are perceived as the masters of the investment universe. These funds (apparently) employ only the best and brightest individuals who take positions that are designed to outperform the market…irrespective of whether it is rising or falling.

Absolute returns (no negative results over a stipulated period of time) are another promise offered by some hedge funds.

If the aura of hedge funds makes them sound too good to be true, it’s because, in reality, most are.

Unfortunately, far too many investors fail to apply this cynical approach and actually believe the “hype” — as we know they are wired to do.

When the founder of the world’s largest hedge fund, Ray Dalio, was asked, “How many hedge funds are worth investing in?”, his response was, “There are about 8,000 planes in the air and 100 really good pilots.”

Many a true word is said in jest.

The following table compares the annual performance of the HFRX Global Hedge Fund Index (since 1998) to other benchmarks…

The Rum Rebellion

Source: Enterprising Investor

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Over the longer term — 1998 to 2016 — the Hedge Fund Index has slightly underperformed.

However, when you take the 1998–2003 performance away from the hedge funds, they have produced dismal performance since 2004.

Initially, the small and nimble hedge fund players did add significant value for their excessive fee structure — a 2% annual management fee plus a performance fee of 20% on gains achieved above a base return, or “hurdle” rate.

The late phase of the dotcom boom in the 1990s provided the hedge fund industry with a lot of low-hanging fruit to profit from.

The obscene amounts of fees extracted from the hedge fund pioneers resulted in nearly every man and his dog hanging out their hedge fund shingle.

The result of this overcrowding in the hedge fund marketplace is demonstrated in the post-2004 performance of this sector.

With so many managers looking to get on the fee gravy train, it means the small universe of undervalued investment opportunities is well and truly trawled over by the hedge fund herd.

Since 2004, the hedge fund average has seriously underperformed the S&P 500.

However, as the hedge funds, in recent years, have outperformed the cash rate (a measly 0.25%), some have still been able to pay themselves their performance fee (in addition to the annual management fee).

Industry insider Simon Lack shone the light on the inequity of the hedge fund fee structure in his 2011 book The Hedge Fund Mirage:

  • From 1998–2010, hedge fund managers earned $379 billion in fees. Over the same period, the investors in their funds earned only $70 billion in gains.
  • Managers retained 84% of investment profits while the investors, who put up the capital, received a paltry 16%.
  • To make matters worse, up to one-third of the hedge funds are only accessible via feeder funds or a fund of funds approach. This adds a further layer of administration fees to be absorbed by investors.

Simon Lack estimates the additional administration fees are approximately $61 billion. When you account for the additional fees, investors actually received $9 billion ($70 billion less $61 billion), and the industry raked in $440 billion ($379 billion plus $61 billion). The final split: hedge funds 98% and investors 2%.

Despite what you may have been led to believe, hedge funds are not in the investment business. They are in the fee-capturing business.

Sure, some hedge funds are worth their weight in gold. But which ones?

Picking the outperformer in advance is random luck, and failure to do so (which is where the majority end up) comes with a hefty price tag.

In classic “don’t let the facts get in the way of a good story” tradition, the industry knows that, when it comes to sexy versus matronly, investors are wired for the former.

Index funds are definitely not sexy. They are very matronly.

But, personally, I find them attractive.

Wafer thin fees.

Transparency — you know the exact portfolio composition of an ASX 200 Index fund.

And, they deliver performance that beats 90% of active (higher fee charging) managers.

If you happen to be in the ten percenters. Well done.

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But that was then, what about now?

Will the 10 percenters of yesterday be the same ones as tomorrow?

Maybe. Maybe not.

Whereas, the index will still be the index. Sure, the weightings and/or companies might be different, but it’ll still be the index that 90% of active managers won’t be able to outperform.

Why the Vlad’s of this world are mystified at losing 98.5% of their money is baffling.

But even more baffling to me is why people overpay for underperformance.


Vern Gowdie,
Editor, The Rum Rebellion

Vern has been involved in financial planning since 1986.

In 1999, Personal Investor magazine ranked Vern as one of Australia’s Top 50 financial planners.

His previous firm, Gowdie Financial Planning, was recognised in 2004, 2005, 2006 & 2007, by Independent Financial Adviser magazine as one of the top five financial planning firms in Australia.

In 2005, Vern commenced his writing career with the ‘Big Picture’ column for regional newspapers and was a commentator on financial matters for Prime Radio talkback.

In 2008, he sold his financial planning firm due to concerns about an impending economic downturn and the impact this would have on the investment industry.

In 2013, he joined Fat Tail Investment Research as editor of Gowdie Family Wealth. In 2015, his book The End of Australia sold over 20,000 copies and launched his second premium newsletter, The Gowdie Letter.

Vern has since published two other books, A Parents Gift of Knowledge, all about the passing of investing intelligence from father to daughter, and How Much Bull can Investors Bear, an expose on the investment industry’s smoke and mirrors.

His contrarian views often place him at odds with the financial planning profession today, but Vern’s sole motivation is to help investors like you to protect their own and their family’s wealth.

Vern is Founder and Chairman of The Gowdie Advisory and The Gowdie Letter advisory service.

The Rum Rebellion