John MacIntosh writes that despite continued high pay, hedge fund managers risk losing business from pension funds and other investors disappointed with the returns
You can make more money by investing in low-cost index funds than in high-fee hedge funds, MacIntosh says
Editor’s Note: John MacIntosh was a partner at a leading global private equity firm. He now runs a nonprofit in New York. The opinions expressed in this commentary are his.
Yet there are clouds on the horizon. While New York City Public Advocate Letitia James, a hedge fund critic, won’t convince mediocre fund managers to “sell their summer homes and jets and return those fees to their investors,” it does seem likely that the 20-year hedge-fund party may finally be over.
America’s largest institutional investor, CalPERS, has cashed in most of its $4 billion of hedge fund investments. Last month, NYCERS, the large New York City pension fund, reached the same conclusion with one trustee dryly noting, “We have not seen the results that we had expected.” And these large investors are hardly alone as the first quarter of 2016 saw the greatest volume of withdrawals since mid-2009, shortly after the peak of the financial crisis.
Commentators have focused on the particulars of why these large investors are bailing out, but the better question is why the hedge fund industry got so grotesquely bloated to begin with, given that so few managers have actually generated the sustained, excess returns that all the fees paid would imply.
The truth is that the average hedge fund – charging 2% of assets and a 20% cut of the profits – has underperformed the market over the last three, five and ten years compared with an index fund charging all-in-fees of as little as .20%, as Warren Buffet famously bet they would 10 years ago.
So what is the attraction of hedge funds? Maybe it’s because their goal of “predictable outperformance” is an article of faith for investment consultants (and finance professors) keen to keep their well-paying jobs. Or because alternative investments – hedge funds, venture capital and private equity – are status symbols for the wealthy.
Or because under-funded pension funds need to pretend, particularly in a low-interest rate environment, they will outperform to delay the day of reckoning when benefits are cut or contributions raised. Maybe it’s just because low-cost index funds are so dreadfully boring while high-fee alternative investments can be a lot of fun.
But what’s done is done, so as investors recover from their high-fee, mediocre-return hangover and work through the self-loathing that should come with it, here are five commonsense rules for wealthy folks and managers of pension funds and college endowments to keep in mind should they ever be tempted by over-promising fund managers again.
Don’t fall for tempting promises
Dismiss any claim of outperformance as simply untrue. Managers flatter themselves by being creative in how returns are calculated, by picking a bogus benchmark, or by cherry-picking a favorable time period over which to calculate performance. Sometimes they just plain lie (Martin Shkreli, who has said the federal charges against him are “baseless and without merit.”) or maintain an elaborate, multi-year fraud (Bernie Madoff). So when presented with returns that seem too good to be true, simply assume they aren’t without very hard evidence to the contrary.
If the returns are real, expect that there’s more risk than meets the eye. In any remotely efficient market, generating above-average returns is easy: Just take above-average risk. But these returns aren’t really above average; they’re just average returns on steroids (in finance-speak, “beta” disguised as “alpha”) which means that if you’re willing take the same level of risk you can produce similar performance without paying exorbitant fees. (For example, it’s a lot cheaper to buy the Direxion Daily S&P 500 Bull ETF for .9% than to pay a 2% fee plus a 20% profit-cut to a manager investing in stocks.)
Will the manager tell you the real level of risk or give you the information to estimate it? Do they even know? Ignorance of risk is the manager’s steadfast ally. In fact, one tried-and-true strategy is to create risky things that nobody — not even the manager — really understands (remember LTCM!) Don’t be the patsy who, entranced by seemingly excessive profits, remains blissfully unquestioning until that sad day comes when the hidden risk reveals itself.
If the nature and level of risk aren’t clear, assume that they fully explain any apparent out-performance. Free lunch is very hard to find.
Even if the risk-adjusted returns have been attractive, remember that it’s probably just luck. Even if the manager really has outperformed on a risk-adjusted basis, it usually reflects luck, not skill. And while it’s better to be lucky than smart, it’s not smart to stay invested with a lucky manager as luck runs out. Always. Unfortunately, no amount of evidence will let you prove whether a period of outperformance is due to luck or skill. And the manager will always have a compelling and coherent explanation for the outperformance in which luck plays little role.
If you want to conclude that the manager’s ability to outperform the market is real and sustainable, then first explain how. There are a few ways to explain how some fund managers can regularly outperform the market even after consideration of their fees. Either they get an earlier glimpse at investment opportunities than their peers, get to invest on better terms, have superior information about the companies they invest in or are just plain smarter.
The best venture capital and private equity firms do get an earlier look at potential deals, can get better terms, may learn about what other managers are doing and can add value though active participation on the board of directors and the ability to give executives high-powered incentives.
It’s different for hedge fund managers, though. Most managers, particularly in fixed income, currency and commodities, can only rely on smarts because they can’t see opportunities first, all pay the same price, and getting better information is difficult (and sometimes illegal).
This is why hedge fund managers are much smarter (e.g. more bridge champions, more physics PhD’s) than their private equity and venture capital counterparts: It’s the only basis on which they compete. But smarts alone is a tenuous basis on which to succeed over the long-term so it should come as no surprise that CalPERs only terminated its hedge fund program (not private equity or venture capital) and NYCERs actually increased its commitment to private equity while cutting hedge funds.
It’s also very dangerous to give money to a manager on the basis of a short track record and a hunch that he – and it’s usually a he – is “really smart.” Even the smartest managers may not know whether their outperformance has been due to luck or skill, making it virtually impossible – other than by waiting – to distinguish the truly brilliant from the lucky-but-clever. And impersonating a great long-term investor is far easier than actually being one as the supply of really bright people is virtually limitless compared with the number of truly extraordinary investors.
Don’t disregard cheating as the possible reason for attractive long-term performance. Investing is brutally competitive, difficult and some people cheat. So great returns must invite some doubt as to whether they were earned honestly. Cheating, whether actually illegal or merely unfair, can help you see deals early (e.g. front-running), get better terms (e.g. trading against your clients, colluding in auctions, etc.) and have better information (e.g. expert networks, good old-fashioned tip-offs). Creative managers even use their smarts to invent new forms of cheating that can be exploited until competitors or regulators catch on. (For example, spoofing trading systems, digging a tunnel through the Appalachians, etc.)
This raises the thorny moral question: If you suspect, but can’t prove, that a manager is cheating, is it OK to invest because you want in on the ill-gotten gains?
The road ahead
The tough times for hedge funds will continue with downward pressure on fees, more withdrawals by large investors, and a long overdue thinning of the herd. This is great news in a society that’s already unequal enough and really can’t afford to exacerbate the situation by continuing to fork over billions in fees other than to those very few fund managers who have demonstrated that they can really deliver the goods.
The shakeout in the industry will bring the predictable slew of disingenuous announcements by erstwhile superstars that “market conditions have changed so this is the right moment to spend more time with my family.” And the practices of those that continue to outperform will, one hopes, come under increased scrutiny from regulators.
On the other hand, ex-fund managers are people too, so it’s nice to know that they will have more time off to enjoy their summer homes, yachts and jets. Maybe they’ll even invite Letitia James out for an August weekend at the beach.
John MacIntosh was a partner at a leading global private equity firm. He now runs a nonprofit in New York. The opinions expressed in this commentary are his.