Is Everything That Didn’t Work Worthless? Part IV

We began this series of posts by examining the sorry state of value investing. We then moved on to making unfashionable arguments on behalf of hedge fund fees and performance. We’ll close the series by looking at the important role hedge funds—and, for that matter, value investing—play in the long-term success of investment portfolios.

Hedge and value tend to exhibit similar performance patterns. During strong up markets they will usually lag. But in flat and down markets they outperform long equities and, usually at least, there is a positive skew to the overall performance. But note that a positive skew isn’t actually necessary for these strategies to play a constructive role in portfolios.

To understand why, let’s get reacquainted with our old friend, variance drain. Variance drain is the phenomenon via which two portfolios can have the same mean return but the less risky one results in greater terminal wealth. I’ve talked endlessly about this subject in my books, white papers and even in this blog, but as a reminder, a convenient formula for calculating the “drain” your performance will suffer from the variability of your returns is C = R − σ2/2, where R is the mean (arithmetic) return and σ is the variance in the return.

Variance drain happens because, in the investment world, losses hurt more than gains help. This is why our geometric returns will always be lower than our arithmetic returns.

Here’s a simple example. Imagine an investor whose portfolio of $1,000 returns 100% in year 1. He now has $2,000. But in year 2 the portfolio loses 50%. Our investor’s arithmetic return for those two years is 25%—pretty darn good. But if you do the math you will find out that the investor still has only his original $1,000. His geometric return is 0%.

Over an entire lifetime of investing, the lower volatility of investing strategies like hedge funds and value matter a lot. We’ll examine this curiosity by following the adventures of the famous twins, Larry and Lucy, over their 50-year investment lifetime.

At the age of 20, Larry and Lucy each received generous $1,000 gifts from their favorite Uncle Greg, on the condition that they put the money in IRA accounts and promise not to touch it for 50 years. Larry and Lucy never withdrew any money from those accounts and they never added to them, either. As it happened, they never changed their initial investment strategies.

Larry, having read everything Jack Bogle ever wrote, put his $1,000 in the Vanguard S&P 500 Index Fund. Larry knew, via Bogle, that active management is for suckers and that hedge funds are for suckers with more money than brains.

Lucy, who thought Jack Bogle was the golf pro at her country club and who had just read a brilliant investment book called The Stewardship of Wealth, put her money in a hedge fund of funds—a good hedge fund of funds, but one that happened to accept $1,000 investments.

Fifty years later Larry and Lucy met for dinner at Applebee’s to compare notes. Over his grilled chicken wonton taco appetizer, Larry pointed out, gloating only slightly, that over the past 50 years his money had compounded, net of fees, at 8%. With a mouthful of green bean crispers, Lucy checked her results and found, sadly, that her money had only compounded, net of fees, at 7%.

“Those high hedge fund fees will kill you every time,” Larry cheerfully pointed out as he ordered his sizzling double barrel whisky sirloin steak entrée.

“But esteemed brother,” replied Lucy as she ordered her seasonal mystery berry and spinach salad, “you are forgetting our dear friend, variance drain. Do you happen to know what the annual volatility of the Vanguard 500 Index Fund was over the last 50 years?”
Frowning into his fireball whisky lemonade, Larry tapped on his phone for a moment and said, “17%.”

Lucy sipped her elegant Sutter Home white zinfandel while tapping on her own phone. “Gosh,” she said, “that’s an awful high volatility, Larry. No wonder your hair is gray and you’re so crabby all the time. My vol was, let’s see, here it is—7%.”

“You can’t eat vol,” Larry pointed out, popping a mini salted caramel pretzel bite into his mouth.

“You can’t eat return, either,” retorted Lucy, chowing down on her green goddess garden goodness wedge salad. “What’s the value of your IRA account right now, exactly fifty years after you opened it?”

More tapping and then Larry smiled and turned his phone around so that Lucy good see the astonishingly high number. Lucy leaned forward, peering into Larry’s phone. “$25,249,” she said. “Not bad for someone who only invests in long-only equity index funds.” Lucy then tapped on her phone and turned it around for Larry to see. “What??” he cried. “$26,509! It’s not possible!”

Larry stumbled away from the table, wondering why he’d subjected his delicate psyche to such huge volatility over all those years for nothing. He was just staggering through the door to Applebee’s parking lot when Lucy called after him.

“Larry, wait!” she shouted, “You didn’t finish your apple chimicheesecake!”

Next up: Loose Change