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.   

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.

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. 

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.

In Search Of: A New Name For "Passive"

One of the many reasons "passive" investing gets dissed is that its name--"passive"--is both misleading and deflating.  Who wants to be "passive"?  The folks who do well in life are active, the ones who have gumption, the ones who get up off the couch and make things happen.  "Passive" investing, moreover, isn't passive--it's active.  Smart passive investors actively determine which types of stocks they want to invest in, actively screen the market to find such stocks, and actively manage their portfolios to make sure they contain only such stocks (and in the proper proportion). 

So smart passive investors, the ones who wouldn't mind earning some respect in addition to superior returns, are forever searching for a new term to describe what they do.  Alas, to date, none has been found.

"Indexing" doesn't work, because "indexing" suggests that the passive investor is simply trying to match the performance of the S&P 500, Russell 2000, or other index.  And now that such strategies are popular, the style suffers from herding, index-reconstitution, and other problems (even thought it still outperforms most active strategies).

"Rules-based investing" doesn't work because...well, because it's boring and vague.

"Factor-based investing" doesn't work because it's mystifying.

"Dimensional investing" doesn't work because...ditto.

"Quantitative" doesn't work because it has already been coopted by "quants."

The latest suggestion, "Equilibrium-based investing", put forth by DFA's Weston Wellington in a recent article, doesn't work because it doesn't mean anything that couldn't just as easily apply to the "active" world.  (Although it is arguably better than "passive").

So the search continues.  One thing is certain, however.  If passive investing continues to be called "passive," those who advocate the strategy will continue to operate at a major marketing disadvantage to their "active" competitors.  In fact, given the inherent connotations of the words "active" and "passive," it is almost certain that the nomenclature was devised by a traditional stockpicker.

Why So Many Advisors Are Incompetent

Dylan Ross submits:  Most financial advisors are not capable of providing good financial advice.  This is not because they are stupid or unethical; many are quite intelligent and almost all are well intentioned.  They can’t give good advice because they don’t know how.

Many advisor trainees hired at Wall Street firms have no more expertise about investing or personal finance than the clients they will be expected to serve.  Many have less.  To ready these green advisors, most firms provide some type of in-house training program.  The training usually focuses on the the firm’s products and how to sell them.  For example, recruits are not taught about the negative impact fees have on returns, they are taught how to justify their fees.  The usual line goes something like this: “Lower fee products don’t come with advice.” Never mind that the “advice” usually amounts to “buy this more expensive product.”

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(New hires also study for the Series 7 Exam, which teaches them about different types of securities, how markets operate, and the regulations they must follow—but not how to give intelligent advice.)

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Brokerage firms make more money selling expensive, actively managed strategies, so their training programs rarely give new advisors an opportunity to objectively compare the merits of passive strategies (indexing).  Advisors are instead armed with talking points to overcome a prospective client’s inquiries about index funds.  Some of the more popular rebuttals include:

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• When you buy an index you are buying all of the market risk that comes with it (falsely implying there is less risk in active management).
• Yes, most mutual funds don’t beat the index, but I don’t use most mutual funds (implies that the advisor can select funds that will beat the index). 

• Indexing guarantees mediocrity (simply incorrect).

The sad part is that the advisor is not trying to pull one over on you; he or she probably believes this.  Advisors also believe that their firm’s rigorous manager screening process is the result of something other than sales agreements and revenue sharing. Advisors mistake sales tactics for universal truths from the start of their careers--and tend to hold tight to these learned biases.

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As they continue to build their practices, the advisors become more invested in those same ideas and their bias grows stronger. Unfortunately, the global effect of having so many pseudo-experts in agreement only perpetuates their misconceptions about fees, market-beating strategies, and other bad advice.

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On the bright side, there are some competent advisors.  The challenge is finding one.  Referrals and references can be misleading because people don’t usually know about their advisor’s shortcomings until it’s too late.  Asking probing questions about an advisors training and experience beyond the basic, “how long have you been at this?” may help uncover what he or she really knows.

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Dylan Ross is a CFP at Swan Financial Planning, LLC.  The opinions expressed in this post are his.

Hussman: Sorry, Market Still Overvalued

In his weekly market letter, John Hussman of the Hussman Funds notes that the current market environment feels a lot like that of the late 1990s and then invokes a sobering statistic to back this up.  Hussman's conclusion is the same as that of Jeremy Grantham, Andrew Smithers, Robert Shiller, and others: the U.S. equity market is still overvalued by at least 30%. 

As with all analyses based on mean reversion, Hussman's assumes that past is prologue.  As a result, if something is "different this time" (which it sometimes is), the concern may be unfounded.  The bad news is that, if something isn't different this time, if past is prologue, the outlook is very grim indeed.  The "mean" in a mean-reversion analysis is in the middle: half of the observations are above and half are below.  A drop of 30% in the market, in other words, would not necessarily take us to the bottom.  It would just take us to the mean.

Hussman:

Ever watch those old Road Runner cartoons where the Wile E. Coyote goes over the edge of a cliff holding an anvil and just hovers there for a moment, while it sinks in that he's in trouble? That's about what this market feels like. In particular, the current environment in housing, financials, and the stock market feels a lot like what we observed in the dot-com bubble in the late 90's. It was the clear (or should have been) that speculation had gone too far, and that the excessive bullishness of investors would probably end badly. But even after individual stocks began to collapse, many investors maintained hope until it was far too late..

...[S]tocks remain very richly valued. The bait taken by investors here is the belief that the market's “price-to-forward operating earnings” ratio is reasonable. Unfortunately, this morsel of bait carries a very sharp hook. “Forward operating earnings” did not even exist prior to the 1980's, and if one proxies it historically as Cliff Asness has done (based on how it relates to other fundamentals with longer records), you find that the historical norm of “price-to-forward operating earnings” is about 30% below current levels. Adjusting for the present elevation of profit margins, the normalized level is probably even lower.

Fama and French Dish, Diss, and Disagree

In this Journal of Indexes (JOI) interview (download below), two of the world's smartest investors weigh in on the strategies that have made Dimensional Fund Advisors one of the most successful fund firms in the world.  Better known as finance professors, Eugene Fama and Ken French helped design DFA's stock-selection and fund-management techniques.  In this interview, Fama and French revisit their original conclusions, poke fun at the arrivistes who have since claimed to have discovered their ideas, and, once again, show why traditional stock-picking is almost always for the birds.

Notable points:

• Fama and French now disagree about the cause of the "value effect"--the phenomenon in which value stocks have outperformed growth stocks over the long term (for more on the value effect, see this post).  French no longer believes that this outperformance represents "distress risk" and, instead, thinks there is some "mispricing" involved (investors underestimating the prospects for value stocks and overestimating them for growth stocks).  Fama, ever the efficient market man, begs to differ.

• Both men are shocked that commentators believe that today's hot product--"fundamental indexing"--is actually something new.  The academic literature, they point out (and DFA), has described the strategy for 15 years.  The advantage of "fundamental indexing" is merely that it captures the value effect.  As French puts it: "It's not even another way [of doing this.]  It's the same way.  I have a friend who calls [fundamental indexing] value investing for clients who don't understand ratios."

• On the "dividend-weighting" strategy used by Jeremy Siegel and WisdomTree: This, too, is nothing new.  Dividends are just another way of sorting stocks to capture the value premium.  Unfortunately, using dividends as the value screening metric is inferior to using book-to-market ratios.  How do Fama and French know this?  Because they've tested all the value metrics.

• Fama still thinks the market is efficient, but French now concedes that some people can probably beat it.  Returns are so random, however, that he just doesn't have enough information to figure out who they are (implication: neither do the rest of us.)

• On whether the value/growth mean-reversions can be timed (Specifically, as I asked in this post:  Can investors use the ratio between value and growth to predict the performance of each asset class?)  According to French, there's no evidence that this works.

• On ETFs: Great tools, as long as they're cheap and passive.

• On behavioral finance: Investors make the mistake of assuming that, now that they know some of the mistakes investors make, they won't make those mistakes.  Unfortunately, they'll probably just make others.

Download fama_french_journal_of_indexes_3_07.pdf

Will the "Value Effect" and "Size Effect" Persist? Do They Even Exist?

In my "dumbest column of the year" post, I suggested that DFA and other smart investors have capitalized on the "value effect" to design better passive funds.  Astute readers pointed out that the value effect is a theory, not a fact, and that it might soon disappear--leaving those who bought "value tilted" or "fundmental-weighted" funds holding an underperforming bag.

This is a complex topic, one that still produces violent arguments in the halls of academia and elsewhere.  Fama, French, DFA, and others attribute some of the superior long-term performance of value and small stocks over large growth stocks to higher risks: stocks get cheap because the companies are in distress (or riskier), and rational investors demand a higher return.  If this view is correct, the effects should persist over the long term, even if they disappear for decades at a time.

One contrary view, held by John Bogle and others, is that the value effect is merely a short-term trend that, like other such trends, will eventually become over-bought.  Having "discovered" that value stocks outperform growth stocks, this theory goes, investors will bid up the prices of value stocks, and this will reduce or eliminate future higher returns (or, more pertinently, result in lower returns relative to growth stocks). 

Common sense and analyses of past data suggest that the latter view--temporary phenomenon--is certainly valid over periods that most investors consider long-term: 1-5 years.  Other analyses, however, show that the value effect has, on average, been persistent over many decades and in many markets, validating the former theory, too.  The same can be said for the size effect.

In the coming weeks, I will assemble some of the most important work on this topic (and please feel free to weigh in with studies, thoughts, and comments, either in the comments section or via email).  For today, I will simply highlight some excellent charts produced by Index Funds Advisors.  These show the frequency with which small and value stocks have outperformed large and growth stocks (scroll down to the bar charts, Figs 9-9 through 9-16), as well as the relative performance of small vs. large over selected time periods (Fig 9-17).  The charts show that:

• Small value outperformed large growth in 58% of 1-year periods from 1927 to 2006.
• Small value outperformed large growth in 97% of 20-year periods over the same 80 years.
• Large value outperformed large growth in 58% of 1-year periods and 92% of 20-year periods.
• The "size effect" showed perfect decile by decile performance correlation over 80 years (smallest 10% outperform second-smallest 10%, etc.)  Over shorter--but still long--periods, however, this performance has completely reversed.
• From 1965-1968, 1975-1983, 1992-1993, and 2002-2006, the smallest 10% of stocks wildly outperformed the largest 10%.
• In all the interim periods, small stocks got absolutely crushed.

These charts illustrate why both camps in the "persistent" versus "temporary" camp have an important point.  Over the truly long-term (80 years), the value and small effects appear to be undeniable.  Over interim periods long enough to feel like eternity, however, small and value stocks get overextended and experienced painful reversion to (and beyond) the mean.

Should investors try to take advantage of either pattern? Both?  Should investors "tilt" portfolios toward value/small, but also try to time the mean-reversion by changing ideal portfolio weights depending on relative valuation?  The latter would depend on whether the mean-reversion can be meaningfully predicted...