INVESTMENT INTELLIGENCER

DeLong: Hedge Fund Comp Fine for Top 20, Silly For Everyone Else

Brad DeLong concludes that the top hedge-fund managers--Simons, Soros, Lampert, Cohen, etc.--who took home an average of $240 million apiece last year (per the New York Times) may have earned their money, but that the average hedge-fund Joe who banked, say, $500,000 to $50 million, almost certainly did not.  No argument here.

The average hedge-fund Joe is a brilliant 25-40 year old with great breadth of knowledge, great information, great speed, and a proven ability to out-trade his or her competition more than, say, two-thirds of the time.  Unfortunately, beating the competition two thirds of the time doesn't come close to offsetting the costs of this trading and the gigantic sum (two and twenty) that said hedge-fund Joe will take home at the end of the year.  Although the hedge-fund Joe's clients, therefore, will likely be impressed with his/her insights, they are also likely to be made poorer by the deal.

DeLong:

Not at the top, further down the food chain, however... it is a mystery how the hedge funds staffed by very smart and hard-working people who nevertheless do not seem to have much of a risk-adjusted edge over the market indices nevertheless collect fees of 2% of assets and 20% of returns each year:

One theory is that is is a disequilibrium phenomenon, and that market entry by those who promise to produce whatever alpha the typical hedge funds achieves and to produce it with lower fees will drive down the compensation structure:

A second theory is that the 2-and-20 fee structure is a sociological fact embedded in the social network of midtown Manhattan and the City of London, and will stick--a modern-day equivalent of Fidelity Investor Services. For a generation, investors in Fidelity funds received net annual returns of S&P - 2.5% + noise, as high fees plus the price pressure that Fidelity generated against itself by herding with the Wall Street crowd took their toll. By contrast, investors in Vanguard received net annual returns of S&P - 0.6%. The gap compounds: Over 35 years Vanguard investors double their relative wealth. This gap drove John Bogle insane. But it did persist.

A third theory, related to No. 2, is that most hedge-fund investors just don't know how to evaluate the services they are receiving and/or are so focused on near-term performance that they are willing to trade away pots of long-term money for a chance to outperform during the next downturn.  My money's on No. 2 and No. 3.   

Sky-High Prices, Overrated Japan

An advisor submits:  Regarding Jeremy Grantham's apocalytic view, here's how I explain the current environment to clients.  Back in 2000, the investment landscape looked like the Alps, with stunning peaks (technology and some other large-cap growth) and deep valleys (REITs, small-cap value, energy, emerging markets).  Today, the investment landscape looks like the Tibetan Plateau, with high valuations in every direction, as far as the eye can see.

I had an interesting meeting recently with a portfolio manager for international equities.  When I asked him to describe a couple of recent portfolio additions, he said that he has been struggling to find anything new to buy at acceptable valuations.  He pointed to the run-up in value, the run-up in small caps, the run-up in emerging markets.  He noted that international markets were up 30% in the last 18 months in dollar terms, up 20% in local currency, and that "obviously" stocks aren't worth that much more now than they were then.

I then asked him how he justified his substantial overweight in energy stocks.  He has something like 22% of his portfolios in energy, vs. 7% for EAFE, and he acknowledged he would overweight even more except that the funds have a policy limiting sector overweights.  Hasn't energy had the same kind of run-up, I asked, as small-caps and emerging markets?

"Can you think of any other industry," he replied, "where prices have tripled?"  He said he assumes $50 oil, which he thinks is conservative, and even with that many energy stocks still appear to be much better values than anything else around.

I also asked him about his substantial underweight in Japan.  The explanation: He looks for high return on capital combined with low valuation -- shades of Joel Greenblatt -- and return on capital is pathetically low in Japan.

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Personally, I continue to have a hard time making sense of Japan as an investment opportunity.  Bulls emphasize that Japan is much cheaper than other developed markets on price/book and price/sales; bears emphasize that Japan is more expensive in P/E terms and that return on capital is awful.  In effect, bulls say, "You can buy assets cheap," while bears ask, "Why throw good capital after bad?"

Grantham: Short the World

Jeremy Grantham's Q1 letter (www.gmo.com) paints a startlingly gloomy picture, even for him: For the first time in history, every major asset class is experiencing a bubble at the same time.  Globally, economic conditions have gotten so good, credit has gotten so accessible, profit margins have gotten so high, and investors have gotten so diversified, that risky assets no longer provide any expected premium over safer ones and there is nowhere to hide.   Even forestry, Grantham laments, has become a mainstream asset class.  The resulting race to scarf up the world's trees has reduced expected timber returns to a paltry 5%-6%.

As before the 2000 crash, Grantham is convinced that it's NOT different this time--and, therefore, will end badly.  He dismisses the idea that, in order for the markets to correct, we will need a catalyst (and, because we don't know exactly what it will be, we're safe).  He ridicules the theory that "private equity" will drive up stock prices indefinitely (and suggests that, in hindsight, this latest bubble will be called "The Private-Equity Bubble").  He acknowledges that predicting the timing of such a correction is impossible and, therefore, that all asset classes might get even more expensive for years (this was what happened in the late 1990s: Grantham and other value-driven forecasters called the top too early and suffered years of predictable ridicule and scorn.  Then the market crashed, and they were heroes.).

Grantham's less-gloomy colleagues point out that bubbles usually peak in a final orgy of excitement, in which markets rocket to levels that previously seemed unimaginable (e.g., 1999 and 2000 for tech, 2005 for housing) and that, globally, we haven't seen such a blow-off yet.  So perhaps, Grantham admits, the party will go on for a while longer.  But, he adds, "bubbles always burst."

 

Hedge Funds: Are They For Everyone?

I'm speaking on a panel today at Lipper HedgeWorld with Ed Easterling of Crestmont Research and Ron Geffner of Sadis & Goldberg LLC.  "Are Hedge Funds For Everyone?"  My answer is "no."

I should say upfront that I am viewing this question from the perpective of those who invest in hedge funds. From the perspective of those who own or work for hedge funds, they are probably the best business in the history of the world (and I would have said this even before today's New York Times reported how much the top 25 managers took home in 2006). 

On the investor side, if one could consistently identify the top hedge funds in advance and be confident that performance that looked fine in one market environment (up) would persist in another (down), the answer would be "Yes--hedge funds are for everyone."  The trouble is that the top funds are hard to identify in advance, even for those with the necessary time, money, and expertise, and many of the best ones are closed to new investors (especially small investors).  This means that most hedge-fund investors will likely be choosing from funds that are merely above-average, average, or below average.  And, there, the picture isn't so pretty. 

Recent academic research suggests that, on average, hedge funds generally produce lower returns and have higher risk than most people think.  Gross performance is blunted by high fees and increasing competition: So much brainpower competes in the hedge-fund industry these days that even brilliant managers often can't overcome the drag of 2-and-20 fees (2% of assets and 20% of gains).  Average hedge-fund risk, meanwhile, is harder to measure than, say, average mutual fund risk, and research suggests that, on average, the likelihood of "extreme negative events" is higher than a standard mean-variance analysis would suggest.  The same research suggests that hedge funds' diversification benefit is often overstated.

The primary drawback of hedge funds, in my opinion, is that the compensation structure often rewards managers who produce results that are no better than one would receive in a low-cost passive strategy: many investors pay 2-and-20 for gross performance they could have bought for 20 basis points.  Currently, some hedge funds do offer investors the ability to invest in risks and opportunities that aren't accessible with passive products.  Within a few years, however, I think it's likely that Wall Street will develop passive products that can replicate (or track) the returns of all but the best hedge funds at far lower cost.  At that point, hedge funds might be "for everyone." 

Until then, however, Jack Bogle's logic holds: the net return to investors equals the gross return minus costs.  And, historically anyway, most hedge funds managers have not produced performance strong enough to overcome their fees.

I discussed these points in some detail in the Wall Street Self-Defense Manual and this recent Slate piece.  Below are links to some of the recent research on the topic:

• Hedge Funds: An Industry in its Adolescence, by William Fung and David Hsieh, 2006.  Excellent overview.  Fung and Hsieh have written numerous papers about the performance and risk-characteristics of hedge funds, many of which can be found here.

• Hedge Funds: Risk and Return, by Burton Malkiel and Atanu Saha.  Argues that hedge funds have lower performance and higher risk than is commonly thought.  This article was immediately attacked by the hedge-fund industry, but, in my opinion, most of the counter-points were not persuasive.

• 10 Things Investors Should Know About Hedge Funds, by Harry M. Kat.  Explodes some of the myths about hedge funds (great diversification!) and discusses the challenges of correctly assessing risk, portfolio impact, etc.

• Hedge Fund Benchmarks: A Risk-Based Approach, by William Fung and David Hsieh, 2004.  An examination of hedge-fund returns using "style-based factors".  Shows that most hedge fund returns can be explained by the performance of the particular strategy, rather than the manager's unique skill.

Hussman Bangs The Bearish Drum. No One Listens.

John Hussman of the Hussman Funds keeps banging away on the impending-market-crash drum, this time in a long interview with Kathryn Welling of welling@weeden.  Hussman's points won't come as any surprise to Investment Intelligencer readers, but they are so rare in the larger world of market commentary today that I'll keep repeating them.  (And when the market doubles from here and stays there for a generation, you can throw both of us to the dogs):

• The market is trading at 19-times "peak earnings" (Hussman's equivalent of the cyclically adjusted P/E).  The common bullish arguments that the market's P/E is 15-times (or less) have no basis in theory or historical fact.  Today's valuation is similar to that of many historical peaks, such as 1929.

• Profit margins have always been mean-reverting, and none of the theories floated to suggest that they will forever remain at today's nosebleed level (50% above their historical average) make sense.  These theories, moreover, are only floated by a handful of thoughtful bulls--the rest don't even bother to try to account for today's high profit margins.

• The long-term profit growth trend line in the U.S. is 6% a year.  The reason everyone thinks (and says) profits will grow at least 10% a year forever is because profits have grown that fast for five years (a.k.a., eternity).

• "Fair value" on the S&P is at least 40% below current levels, even if one makes allowances for the (unlikely) possibility that cheap labor in China and India have permanently improved the profitability of U.S. corporations.

• The market might go up another 10% before it has a typical 10% correction.  From now until after this 10% correction, however, the market will have been outperformed by T-bills.

Hussman does not go so far as to make a forecast, but, for him, he comes awfully close. And given these data points, who can blame him?  He also notes that rising interest rates usually suggest that mean-reversion will come sooner rather than later (which it certainly did in 2000).

After having lived through the 1990s, and been on the opposite side of this argument, I can confirm that long-term valuation metrics are worthless at predicting near-term market movements: In the late 1990s, bears like Hussman were not "cautious," they were "wrong," and year-after-year they were carried out on stretchers.  This said, after the market finally collapsed, they looked pretty good.

Flawed Logic: Jason Trennert Barron's Interview

This week's Barron's interview featured Jason Trennert of Strategas Partners.  Jason is bullish about the U.S. market and bearish about emerging markets.  Much of his logic is sound, and his conclusion is fine--the U.S. market goes up about two-thirds of the time, so predicting it will go up this year is rarely a dumb bet.  One of Jason's points is flawed, however:

We expect $93 for S&P 500 operating earnings in '07, and that puts the market at roughly 15 times earnings...The downside risk is low because P/Es are so low.

P/Es are not "so low."  In fact, they're not even "low."  To get to "15-times earnings", Jason is looking at "forward operating earnings" (an estimate).  He's then comparing it to last-twelve-months earnings.  Cliff Asness has written in detail about the folly of this apples-to-oranges comparison.  According to Cliff, the average "forward operating earnings" P/E is about 11-times, not the 15-times that Jason and other contemporary bulls throw around.  This 11-times, moreover, is an average--so half the time the market's P/E has been below this level. 

And then there's the profit-margin problem.  As discussed often in this forum, profit margins are 50% above their long-term average and at 50-year highs.  To compare today's P/E multiples to historical average multiples, you have to believe that today's profit margins will stay where they are.  Anything's possible, but this seems extremely unlikely.  At the very least, the profit-margin question is deserving of 1) acknowledgement, and 2) an explanation.  In Barron's, anyway, Jason didn't have either.

The market may go up, but, if so, it won't be because P/Es are low.

Easterling: Earnings Do Not Grow 6% Every Year In Perpetuity

The seemingly prudent consensus these days is that corporate earnings growth will slow from the torrid double-digit pace of the last few years and settle in at a more normal rate of, say, 6% per annum (the long-term average).  Alas, this consensus is anything but prudent.

As fund-of-funds' manager, analyst, and SMU adjunct professor Ed Easterling writes, earnings just don't behave that way.  Yes, they average about 6% a year (6.6% in Ed's 80-year model).  But they achieve this average by shooting up for 3-5 years, collapsing for 1-2 years, shooting up for another 3-5 years, and so on.  In other words, for all of recorded history, earnings have followed a 3-steps-forward, 2-steps-back pattern, not safe, smooth trend-line growth.

So, what's the problem?  Well, as previously discussed, profit margins--"one of the most mean-reverting series in finance" (Jeremy Grantham)--just hit a 50-year high of 14% of GDP, as compared to the 9% average.  As Ed Easterling points out, profits have also now grown strongly for 5 years in a row.  According to Ed's data, there has been only one business cycle since 1950 in which profits grew for more than 5 years in a row (in the late 70s).  In the sixth year of that expansion, moreover, growth was miniscule, and in the following two years, it collapsed--taking the stock market to a 16 year low. 

As of this writing, meanwhile, "prudent" forecasters are expecting profits to continue to grow for not only 2007 but 2008--what would be the 7th year in a row.  Is this possible?  Anything's possible.  Is it likely?  A review of the business cycles of the past half-century suggests the answer is an emphatic "no."

If, instead of setting a record for consecutive years of impressive growth, earnings behave the way they normally do--collapse for a year or two--what is the stock market likely to do?  Happily deliver another two years of low-volatility, near-double digit growth?  We could do that math, but then we might be accused of always being the bearer of bad news. 

 

 

Mauboussin: Why the Market is Smarter Than You Are

Most people who write about the wisdom of crowds offer colorful anecdotes about crowd intelligence but don't explain why groups are smarter than individuals.  In a recent piece, Explaining the Wisdom of Crowds, Legg Mason strategist Michael Mauboussin solves this mystery.

Drawing on a book by Scott Page (The Difference) and some of his own experiments at Columbia Business School, Mauboussin first observes that, in order for crowd wisdom to prevail, several conditions must be met:

• The group must be cognitively diverse (the individuals in the group must have different approaches to analyzing and solving problems).
• There must be a way to aggregate each individual's opinion into a collective view (such as a stock market).
• There must be incentives: rewards for being right, punishment for being wrong.

In most cases, the stock market easily satisfies all three conditions.  (Mauboussin has argued in the past that part of what happens during bubbles is that there is reduced cognitive diversity, as most investors begin to think and invest alike). 

Mauboussin then describes three distinct types of situations in which groups are wiser than individuals. In the first, the "needle-in-the-haystack," a subset of the group knows the correct answer, but the majority does not (Mauboussin uses the example of the audience on Who Wants to Be a Millionaire).  Here, the crowd's "best guess" is superior because the subset of people who know the answer ensure that the correct answer is the most popular choice (everyone else's guess is random).

In the second and third cases, which are closer to the situation in the stock market, no one in the crowd knows the correct answer, so it must be estimated.  (In the stock market, no one knows what stocks are worth because the valuation process is subjective and because the key variable--future cash flows--is unknown).  In these cases, Mauboussin attributes the crowd's wisdom to Page's "diversity prediction theorem," which states the following:

Collective error (the difference between the correct answer and the group's average estimate) = average individual error minus prediction diversity (the dispersion of the individual estimates).

Mauboussin invokes his Columbia experiments--"guess the number of jelly beans in the jar" and "predict the Oscar winners"--to show how this theorem works.  He also summarizes the theory's implications, all of which apply to investing:

1. A diverse crowd will always predict better than the average individual.  Not sometimes.  Always. 
2. Collective predictive ability is driven by average individual accuracy and diversity.  In other words, a crowd composed of simpletons who think the same way will be less intelligent than one composed of independent-minded geniuses or experts.
3. The group is often smarter than not only the average individual, but the smartest individual.

The last point is critical for investors.  Because of our innate overconfidence, we quickly dismiss the fact that a diverse crowd is always smarter than the average individual.  (Most of us think we're above average).  What is far harder to dismiss is the fact that the crowd is often smarter than all individuals. 

In instances in which the crowd is not smarter than all individuals, moreover, the individuals who beat the crowd usually change with each successive prediction (which gives the investment media a parade of new gurus and "fallen stars" to write about).  Just because you are occasionally right when the market is wrong, in other words, doesn't mean you usually will be. 

Kasriel Blasts Rose-Goggled Economist, Defends LEI

Nothern Trust's Paul Kasriel, whose recession-warning indicator is flashing yellow, devotes an entire eContrarian to poking fun at another economist, Michael Lewis, who scoffed at Kasriel's advocacy of the LEI as a decent recession-predictor. 

Lewis appears to have taken the same position as most economists: The LEI isn't a perfect recession predictor, so even though it is suggesting that there will be a recession, there probably won't be one.  Kasriel argues that this interpretation is bass-ackwards: The LEI is a pretty darn good predictor of recessions, so there probably will be one.  (For good measure, Kasriel throws in his personal Kasriel Recession-Warning Indicator, which, when combined with the LEI, has never given a false signal.)

Who's right?  Time will tell.  But of the two economists, Kasriel appears to be deriving his thesis from the data, while Lewis appears to be doing it the other way around.

Costs Matter: Vanguard Wins Again

Low-cost fund leader Vanguard had another strong year in 2006, with 78% of its funds beating their peer-group averages.  Over longer periods--three, five, and ten years--the percentage is even higher: more than 80%.

This performance, of course, has nothing to do with superior stock-picking and market timing--and everything to do with costs.  The industry-wide average mutual fund expense ratio was 1.27% of assets in 2006.  The average Vanguard fund expense ratio was 0.21%.  Since 1975, moreover, Vanguard's average expense ratio has dropped to one-quarter of its original level--while the industry-wide average has risen.

Given Vanguard's consistently strong performance, it is no wonder that it now manages more than $1 trillion of assets and is the second largest fund firm in the world.  What is a wonder is why more fund companies haven't copied Vanguard's "secret formula."

Actually, it's not a wonder.  Most other fund companies are for-profit corporations, many of them publicly held.  For-profit corporations, especially publicly-owned ones, have impatient shareholders to please.  And for impatient shareholders, even a three-to-five year time horizon is eternity.