How do hedge funds get away with it? Eight theories | Hacker News Reader

How do hedge funds get away with it? Eight theories

newyorker.com

108 pointstristanj27 comments

The second point is actually a point for hedge funds. The S&P 500 went from a high of 1576 near the end of 2007, to a low of 666 in the beginning of 2009 (October 07 to March 2009, specifically). Commodities had similar losses. If hedge funds only lost 20% when the general market lost almost 60%, they are a pretty good hedge against risk.

This is one example of a number of ways the article is weirdly disingenuous. Thea author compares returns to equities but risks to nothing, as you point out. Separately, when he cites an estimate of 3.01% annual return from alpha and 4.62% from beta, all he has to say is that "most" of the returns are from beta and that fees are high, pretending not to understand that returning 3% per year due to alpha after fees would actually be quite impressive and valuable.

Except the author also states:

>Gross of fees, the annual return to investors over the period from 1995 to 2009 was 11.42 per cent. Management and performance fees reduced this figure by 3.79 percentage points.

to 7.63 combined from alpha and beta

>Over the same period, the S&P 500 generated an annual return of 8.04 per cent.

The author's point is that saying '%3 per year due to alpha after fees' is disingenuous since the returns aren't actually higher.

It's pretty disingenuous to compare numbers from two different time spans. I don't know where the authors numbers come from but he says the drop was 20% in 2008.

Your numbers add an additional 6 months during which the S&P 500 dropped significantly: https://www.google.com/finance?q=INDEXSP:.INX

additionaly, the time period you cite seems hand picked to start at the high and end at the low.

You're right, the period was "hand picked", but that's because I was looking at a 5 year graph with the high and low marked, and just used those numbers. The movement before/after 2008 wasn't the 40 percentage points that would be needed for the hedge funds to do as poorly as the market, so I didn't bother.

But I just looked the exact numbers up. The S&P 500 opened January 2nd at 1467.97 and closed December 31st at 903.25. A 38.5% loss instead of the 60% I said, but that's still almost twice the loss of the hedge funds.

My problem with articles like these can be seen in the title. The best way to get to an answer of the question I believe he thinks he is asking (Why do people continue to give money to hedge funds despite evidence that on average, you are better off with the 60-40 stock/bond mix?) would be to present what hedge funds are, present the alternatives, and delve into the reasons. Now, he does most of those things in the piece. The problem is that his original question was already biased - how do they "get away with it." He assumes that there is something going on that blinds all who invest in hedge funds, when in reality, the truth is much closer to this: Those who invest in hedge funds think they've found the one that outperforms average.

TL;DR - hedge funds are for the more risk-tolerant (I agree with his issues on pensions and endowments being invested in riskier vehicles, but that's a separate issue from the question he posed).

This article considers hedge funds in the aggregate, which seems to me to be a fallacy. It doesn’t consider variation within a category which we can usefully select against.

“Money in hedge funds is a bad investment” seems similar to saying “going to college is a bad investment,” when the value of a college degree is highly dependent on institution and major. CS at Stanford may be a fabulous investment, while Folklore/Mythology at U of Phoenix may not be.

So which fund will do well in the future?

The difference is that past performance is a good predictor of future results for college education.

Well, the reality is that the top ~5% of hedge funds generate all the returns and have real alpha. The rest are beta + noise - transaction costs.

Not dissimilar to the way venture returns are distributed. Only the top startups manage to become big companies and provide a sizable return to their investors.

So hedge funds get away with it the same way most startups get away with it. For better or for worse, the investors do not have the ability to accurately discriminate.

Exactly. And the ordinary person (even through an ibank) will not be able to gain access to the best funds.

And it would not matter if he/she could, because there is no good way to tell what the best funds are in prospect.

The lack of transparency explains most of this.

Investors expect the Hedge Funds to have some inside info.

For example, I've heard some hedge funds have "friends" who are staffers for congressmen. It's quite profitable to know what laws will change before everyone else does.

The investors may be recognizing that hedge funds are profiting from political corruption, & choose to look away from the ugliness & pay the fees in order to get in on the deals.

This is it. Only insiders win, and people think that they've put their money with real insiders.

Its not just hedge funds. The same could be said for ALL active investment managers (and even many "index" funds). This has been well know for decades[1].

Of course people who manage their own money do even worse[2]!

Luckily we have index funds and some of them are well managed (i.e. deliver what they say at the lowest possible cost).

[1] http://www.stanford.edu/~wfsharpe/art/active/active.htm

[2] http://www.traderslaboratory.com/forums/attachments/30/26024...

Right, but hedge funds are less transparent and have a greater mystique than other managed funds right now.

BTW my takeaway from the article is I should diversify more into bonds, and bond index funds are not as compelling, relative to managed funds, as stock index funds. So I need to do some research.

Hedge fund managers are fund managers. In general, fund managers make money in proportion to the magnitude of funds under their management. This proportion tends to be bigger for the hedgies than for other fund managers. (Often so-called `2 and 20' fees are charged: 2% of funds under management and 20% of investment gain (often subject to a high water mark) per annum.)

All else being equal, good performance leads to inflows and poor performance to outflows. However, many institutional investors have been increasing their hedge fund allocations despite the hedge fund world underperforming typical simple passive strategies over the past five years. This could be in the hope that the hedgies will outperform during the next bear market / downturn / financial crisis; after all, the whole point of hedge funds is supposed to be to achieve reasonable positive absolute returns come what may.

through hedgies the institutionals get access to such investments as late stages financing rounds in the Valley. This is btw what feeds current (presumably last, at least until new huge money come in) stage of the bubble we're right now in.

Hedge funds get away with it because no one who invests in a hedge fund is investing in the average hedge fund. The average hedge fund performs about as well as the S&P 500. Ok. However, I doubt you could find anyone with money in a hedge fund (knowingly, at least - the investment of endowments and pensions are a different issue than the one I am addressing) who would claim to have invested in one with "average" performance. The upside of hedge funds is much higher than safer investment vehicles. That's why people keep using them. The issue is the same one that plagues law students going to schools with bad employment outcomes - people are completely capable of understanding likely outcomes and expected performance. They are even better at believing that they are the positive outlier.

Yale's endowment report offers a straightforward discussion on why they invest heavily in hedge funds, private equity, venture capital etc.

TL/DR: it's the first three reasons from this article.

http://investments.yale.edu/images/documents/Yale_Endowment_...

Here's my theory: 2/20. Their outrageous fees give the managers so much money that they can buy off all detractors, and pay others who are perhaps on the fence to push their product.

At this point, there is so much money invested in hedge funds ($2.1T), I'd argue there is no alpha left to harvest. Any money invested in HFs at this point is just a pure wealth transfer.

I'd also stipulate that the perceived lower risk of hedge funds could somewhat in part be attributed by HF's reluctance to mark down their investments to market clearing levels in 2008. Index Funds and Mutual Funds who mostly traffic in securities that have official closing prices have no leeway to understate the true volatility of their investments.

I think this volatility understatement problem is probably a bigger problem then survivorship bias from the terms of an investor making asset allocation decisions.

They main idea of a hedgefund, as I've understood it is to generate uncorrelated returns. The idea is that by owning lots of uncorrelated assets you will have less volatility for the same return. Hence I think a better comparison than 60stock/40bond vs 100%hedge could be for example 60stock/30bond/10hedge against 60stock/40bond.

The most glaring error in this article is that the author is talking about the hedge fund industry as a whole, but he uses the S&P 500 as a benchmark. Hedge funds that don't invest in equities are not, and should not be, benchmarked to the S&P 500.

1) > Hedge funds that don't invest in equities are not, and should not be, benchmarked to the S&P 500

Why not?

2) So what DO you benchmark the industry as a whole against?

In an efficient market, we would expect the after-fees returns of hedge funds to be no better or worse than any other asset class (adjusting for risk, beta, etc.)

So there really is no puzzle here.

This isn't hard to understand. As P. T. Barnum supposedly* once said, "There's a sucker born every minute".

*http://en.wikipedia.org/wiki/There%27s_a_sucker_born_every_m...

After 3 decades of deregulation[1] and the 2008 financial crisis which caused a world-wide meltdown... Still asking these kind of questions is naive, stupid but most of all dangerous[2].

[1] http://en.wikipedia.org/wiki/Freefall:_America,_Free_Markets...

[2] http://www.nytimes.com/2009/07/17/opinion/17krugman.html

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