Is Everything That Didn’t Work Worthless? Part III
We’re talking about nobody’s favorite subject, hedge funds. Last week we dispensed with the ugly topic of hedge fund fees, and this week we’ll take a deep breath and tackle the even more noxious topic of hedge fund performance.
On the surface, the only way to describe recent hedge fund performance is “terrible.” Over the past five years, for example, while the S&P 500 was producing north of 16% per annum (!), the HFRI Fund of Hedge Funds was producing about 3%.
Okay, now that we’ve got that out of the way, let’s begin thinking like successful investors, rather than dumb money chasing whatever’s hot. Who, in fact, cares what the S&P did? If we wanted to own the S&P we know how to do it. Hedge funds are doing something very different, and if we want that, which we do because we’re thoughtful, successful, long-term investors, we’ll just have to accustom ourselves to a return stream that is different from that of the S&P. Sometimes that return stream will be better and sometimes it will be worse, but the fact that it’s different is what makes it valuable.
But before we get to that, let’s expand our invest horizon beyond US stocks, especially since those stocks are now priced at nosebleed levels thanks to our annoying friends at the Fed. In order to build a diversified investment portfolio, we need to own a lot more than US stocks, so let’s put hedge fund performance in that broader context.
In the process we’ll not look at the HFRI benchmark, which shows the performance of the average hedge fund, because investors in their right minds would never buy an average hedge fund. Instead, we’ll look at the best of those funds, the ones selected by the better endowments and wealth management firms and which, as noted in my last post, have produced roughly 3% more than the average fund. So how did these hedge funds stack up against other asset class returns?
Non-US developed country stocks produced almost 8% over the past five years, better than the best hedge funds at 6%, but not light years better. And keep in mind that the ECB and the BOJ were also busily making their rich citizens richer and their poor citizens poorer, aping the Fed.
Emerging markets equities produced 3% over the past five years, half as much as hedge funds and with vastly greater volatility.
Municipal bonds also produced about 3% over this time period, with somewhat less volatility than hedge funds but also half the return.
US Treasuries produced 1.1%.
Cash produced nothing.
In other words, viewed from anything other than the parochial perspective of the S&P 500, while hedge fund performance was nothing to write home about, it was also nothing to get alarmed about, either.
Like value managers, hedge funds, even the best of them, cannot produce outstanding performance when a stock market is rigged to go only up. A typical long/short hedge fund manager will be only about 60% net long – maybe a bit more sometimes – and therefore the fund cannot, by definition, beat a Bull Market. Short sellers are obviously dead meat. More complex, absolute return hedge funds require fundamentally driven markets to open up arbitrage and mispricing opportunities. About the only funds that have any chance of producing reasonable performance in a rigged market are activist funds that are creating value through their own actions.
In any event, the important point about hedge funds is not how they did in the recent past, other than to understand why that performance came about. Like value managers, the important thing is to understand how hedge funds are likely to perform in the future. And here the news is much more positive.
In fits and starts the Fed is gradually moving away from its catastrophic Quantitative Easing program and is trying to raise rates to more normal levels. In this case it’s actually way behind the market, as bond yields have soared recently, well in advance of the Fed’s puny bump-up in rates a few weeks ago. (Between October and yearend Treasury yields rose more than 8/10 of 1%, the most in 22 years.)
As Fed interference slowly evaporates, stock markets will, for the first time since 2008, begin to respond to fundamental forces and to operate fairly. In that environment hedge fund managers will, as they have done for so many years, prove their worth. Going forward, a portfolio tilted toward value and hedge will be a valuable thing to own, but it will be owned only by a very small group of sophisticated investors. Everybody else will ride the Vanguard S&P 500 Index Fund straight to perdition.
Next up: Is Everything that Didn’t Work Worthless? Part IV