Smart Investors Know (Good) Hedge Funds Diversify Their Portfolios

Hedge funds tend to take a beating in the financial media. It seems like every week we see at least one new article from a major financial news center, pointing out how hedge funds continue to underperform major indices year after year, and wondering with astonishment how any investor could possibly still consider allocating any funds to these money-drains. I suspect part of the motivation for these pieces is regular schadenfreude, and some of it is writers knowing that their audience lacks sophisticated (and usually basic) financial knowledge, and therefore will gulp down any analysis that will provoke some kind of emotional response (those fucking rich hedge fund managers don’t deserve a damn dollar of their money!!). Some of the analysis you see is actually reasonable, but usually oversimplified.

I won’t link to any specific pieces that I find to be poorly constructed, mostly because there are so many, it’s easy to find them any time. But here are a couple good posts that take a more nuanced view, written by well-known professionals (outside the financial media), Ben Carlson and Cliff Asness. (I will echo some of their points here)

Now, as someone who has worked for one of these institutions for 7 years, I like to think I have a better understanding of this industry than just about all the financial writers that occasionally write hedge fund articles. Of course, that also means I have a significant bias. But I’m not writing this simply to defend hedge funds, nor do I feel like I need to. Somehow all the hedge fund bashing articles haven’t yet convinced the big institutional managers from allocating a portion of their assets to these alternative investments. Huh, wonder why that is?

The main point I’d like to make is that the analysis you see within most or all hedge fund trashing articles is oversimplified and usually worthless. The general lack of understanding of basic finance displayed by the writers of these things is astounding. The primary problems with the typical “hedge funds continue to underperform and STILL charge insane fees” article are:

Compiling an index of hedge funds is kinda stupid. This is such a broad term, it’s hard to define what should be in the index.

It’s rare to see someone compare the “hedge fund index” to a benchmark on a risk-adjusted basis. If you fail to consider risk in your comparison, you get an F in basic finance. Stop writing about finance. You are incompetent.

Still, the aggregate set of hedge funds is unlikely to beat a good benchmark, even on a risk-adjusted basis, over the long run. That’s because we all compete with each other, and if my fund is winning, some other fund is losing. Subtract fees, and the aggregate will probably underperform. But here’s the big, big secret that (almost) nobody seems to understand. Outperforming a benchmark is NOT THE POINT OF HEDGE FUNDS. Or other alternative investments. Sure, some funds may exist (which they probably shouldn’t) to try to outperform, but most will fail, and these funds are only worth investing in if you can pick the winners ex ante. Which is really hard, and requires a lot of resources.

So what is the point of investing in a hedge fund? Diversification. This seems obvious to me, but apparently 99.9% of the financial media can’t comprehend this incredibly advanced concept. Even if a fund underperforms whatever standard financial index you compare it with, it can still improve the risk-adjusted return of your portfolio, provided it is sufficiently uncorrelated with your other assets. That’s the most important thing here, and it doesn’t necessarily require great resources to figure out which funds are real diversifiers. Unfortunately, most available hedge funds are NOT great diversifiers. They pick stocks just like active mutual fund managers, charge higher fees, and usually do rip off their customers. So yes, some of the criticism directed at hedge funds is legit, but it really belongs to a (large) portion of the funds, not all of them. See Sturgeon’s Revelation.

So to sum up what I want to say: when evaluating (a) hedge fund(s), single out those that act as actual diversifiers to an investment portfolio, and see how they improve or degrade the risk-adjusted return of that portfolio (you can also look at drawdown mitigation). Ignore those that have a really high correlation to the other assets (including when you consider allocation). Comparing an indiscriminate aggregate of hedge funds to some benchmark may give you sadistic pleasure, but it’s fucking stupid.

Disclosure: This post reflects my opinions only, and does not constitute an offer of any kind.

Sophisticated vs. Unsophisticated Investors

Noah Smith has a post on Bloomberg View today talking about research that shows that rich investors tend to dramatically outperform not-so-rich investors because wealthier investors are more sophisticated (generally are more educated in finance). I haven’t read the papers he links to, so my post here will be limited to one thought I have regarding a major point of concern brought up in Noah’s post; that the deviation in performance between sophisticated and unsophisticated investors may increase as the average level of financial sophistication increases (everyone becomes more financially savvy).

Again, I’m not familiar with the model that makes this claim, so this is really just a knee-jerk instinctual reaction. But I don’t think this claim makes much sense, for the simple reason that most of the deviation in performance between the two groups probably comes from the sophisticated investors making fewer stupid mistakes, rather than this group showing its ability to outperform some passive benchmark.

One of the charts shown in Noah’s post, reproduced from this paper, shows the cumulative returns from 1989-2012 for the two investor groups:

Sophisticated investors see $1 invested in 1989 turn into $5.32, while the unsophisticated group only ends up with $3.28. Yet a passive investor putting in $1 into the S&P 500 in 1989 and fully reinvesting dividends would end up with $7.31 (that number comes from here). Now, of course, few if any investors would allocate all their assets in equities; some of that money would go into bonds, which generally return less over the long run than stocks. But the data here seems to focus on equity returns.

So while this comparison is a bit of an oversimplification, I don’t see much credibility to the claim that these two investor classes are likely to diverge over time as everyone becomes wiser about investing. Beating the market is hard. Really hard. (I know as well as anyone; I’m a professional trader). Teach the least knowledgeable investors enough not to be stupid with their investments, and eventually they should catch up to the “sophisticated” class (My job has taught me that so-called sophisticated investors often make the same mistakes as everyone else).