A new post on my blog on why hedge funds have failed

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A new post on my blog on why hedge funds have failed

Postby larryswedroe » Fri Mar 22, 2013 2:54 pm

http://www.cbsnews.com/8301-505123_162-57575815/hedge-funds-are-too-big-to-beat-the-market/

Another example of the tyranny of the efficient markets at work
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Re: A new post on my blog on why hedge funds have failed

Postby Random Musings » Fri Mar 22, 2013 3:34 pm

larryswedroe wrote:http://www.cbsnews.com/8301-505123_162-57575815/hedge-funds-are-too-big-to-beat-the-market/

Another example of the tyranny of the efficient markets at work
Larry


I assume the alpha shown in after expenses? Since current large asset base on hedge funds makes alpha close to zero, the -4.5% implies high costs of ownership and a little underperformance too.

No wonder some of these funds are "allowing" the little guys to play now.

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Re: A new post on my blog on why hedge funds have failed

Postby larryswedroe » Fri Mar 22, 2013 4:07 pm

RM

I would assume that as well.

Also the logic is simple. In this world which is the scarce resource; Investor capital or ability to generate alpha? Obviously it's the latter. What amazes me is that people think that they, the plentiful resource are entitled to the alpha. If there is any it should go to the scarce resource--those that can generate it. In real world that is what happens. The top alpha generators raise their fees, either that or more money comes pouring in and then the alpha disappears for that reason. Either way it disappears as far as investors go.
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Re: A new post on my blog on why hedge funds have failed

Postby rmelvey » Fri Mar 22, 2013 4:24 pm

How should we think about that supposed pool of alpha available to hedge funds when net alpha = 0 when thinking about the entire market?
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Re: A new post on my blog on why hedge funds have failed

Postby larryswedroe » Fri Mar 22, 2013 4:27 pm

There are clearly some mispricings.
We know for example that the stocks active managers pick do outperform, but by not enough to cover their costs. Individuals mess up, chasing returns for example and showing preferences for positively skewed assets which have very poor returns
Problem is just not enough victims to exploit.
And once anomalies are uncovered they tend to disappear. AT one time convertible arb was a big winner. But today like 90% of converts owned by institutions, so that opportunity mostly gone.
Hope that helps
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Re: A new post on my blog on why hedge funds have failed

Postby afan » Fri Mar 22, 2013 7:01 pm

An unbiased sample of the entire hedge fund industry generated 9% three-factor alpha? That is amazing, and much higher than any other study I have seen. Where did the idea of of an alpha for the industry come from? One could estimate what the alpha may have been, but what does it mean to identify alpha "for" hedge funds, as opposed to other active managers?

The Fama French luck vs skill did not have even the top few percent of mutual funds with annual alphas anywhere close to 9%. They also found the industry alpha before fees to be not significantly different than zero. The active managers were not picking stocks that outperformed the market. Some have made that finding, but pre fee out performance does not appear to be a consistent observation.
Last edited by afan on Fri Mar 22, 2013 7:21 pm, edited 1 time in total.
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Re: A new post on my blog on why hedge funds have failed

Postby dharrythomas » Fri Mar 22, 2013 7:21 pm

Larry,

Thanks. Informative as always.

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Re: A new post on my blog on why hedge funds have failed

Postby larryswedroe » Fri Mar 22, 2013 8:33 pm

afan
The hedge fund industry did generate high profits in the early days when it managed small amounts of capital. The hedge funds played in very different spaces than public mutual funds.

The very act of their exploiting the anomalies made them go away --or at least shrink at first, then go away. If interested more in this in my Alternative Investment book there is a detailing of the LTCM disaster ---high profits at first, then ....


I have no idea how Hsieh calculated that $30b.

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Re: A new post on my blog on why hedge funds have failed

Postby cbeck » Sat Mar 23, 2013 1:08 am

larryswedroe wrote:http://www.cbsnews.com/8301-505123_162-57575815/hedge-funds-are-too-big-to-beat-the-market/

Another example of the tyranny of the efficient markets at work
Larry


Other than the lower management fees, why isn't buy and hold of index funds subject to the same disappearance of the advantage of an investing strategy? Or do lower management costs explain all the difference?
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Re: A new post on my blog on why hedge funds have failed

Postby larryswedroe » Sat Mar 23, 2013 8:27 am

cbeck
See my Wise Investing Made Simple, with a chapter on What if Everyone Indexed.



A shorter answer though is here
http://www.cbsnews.com/8301-505123_162-37842180/what-would-happen-if-everyone-indexed/

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Re: A new post on my blog on why hedge funds have failed

Postby llluminate » Sat Mar 23, 2013 5:22 pm

larryswedroe wrote:There are clearly some mispricings.
We know for example that the stocks active managers pick do outperform, but by not enough to cover their costs. Individuals mess up, chasing returns for example and showing preferences for positively skewed assets which have very poor returns
Problem is just not enough victims to exploit.
And once anomalies are uncovered they tend to disappear. AT one time convertible arb was a big winner. But today like 90% of converts owned by institutions, so that opportunity mostly gone.
Hope that helps
Larry


Is there any data on how much active managers outperform before fees? It gives me hope that I might be able to outperform on my own capital, since I will obviously avoid the fees (other than transaction costs).
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Re: A new post on my blog on why hedge funds have failed

Postby larryswedroe » Sat Mar 23, 2013 5:49 pm

illuminate
Yes there is

A study by Russ Wermers, published in the August 2000 issue of the Journal of Finance, took an extensive look at the stock selection skills of active fund managers. His study, covering the 20-year period 1975–1994, covered a universe of 241 funds at the start of the period and 1,279 by the end. In order not to inject survivorship bias into the data, Wermers’ total database included 1,788 funds that existed at any time during the period.
Werner not only sought to find out if active managers could pick stocks that would outperform, he also examined the impact of transactions costs and of non-equity holdings (bonds and cash to meet redemption requirements). Further, his study also adjusted returns for risk —exposure to size, value and momentum effects.
Wermers’ findings were very consistent with the results of previous studies. The following summarizes his findings:
• On a risk-adjusted basis the stocks active managers selected outperformed their benchmark by 0.7% per annum. In 13 of the 20 years encompassed by the study, active managers outperformed the S & P 500 Index. Outperforming the market is a zero sum game—if there are winners, there must be losers. Wermers’ findings are consistent with the findings of studies by Brad Barber and Terrance Odean. Their studies on the behavior and performance of individual investors found that the stocks individuals buy underperform the ones they sell. It seems that professional active managers are exploiting the mistakes of individual investors.
• The 0.7% advantage provided by stock selection skills (exploiting the mistakes of individual investors) was more than offset by expenses incurred in the effort. These expenses included bid/offer spreads, commissions, market impact costs, operating expenses and the drag of cash or fixed income investments (which underperform the market).
Wermers’ study found that the returns of active managers were reduced by approximately:
• 0.7% per annum due to holding non-equity assets. Active managers generally hold some amount of cash (or cash equivalents) in attempts to time the market, while waiting to find what they perceive to be an undervalued security, or as reserves to meet shareholder redemptions. Some managers even hold longer term fixed income investments in an attempt to outperform equities.
• 0.8% due to fund operating expenses.
• 0.8% due to transactions costs (bid/offer spreads, commissions, and market impact).
The total negative impact of expenses was 2.3% per annum.
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Re: A new post on my blog on why hedge funds have failed

Postby llluminate » Sat Mar 23, 2013 9:53 pm

larryswedroe wrote:illuminate
Yes there is

A study by Russ Wermers, published in the August 2000 issue of the Journal of Finance, took an extensive look at the stock selection skills of active fund managers. His study, covering the 20-year period 1975–1994, covered a universe of 241 funds at the start of the period and 1,279 by the end. In order not to inject survivorship bias into the data, Wermers’ total database included 1,788 funds that existed at any time during the period.
Werner not only sought to find out if active managers could pick stocks that would outperform, he also examined the impact of transactions costs and of non-equity holdings (bonds and cash to meet redemption requirements). Further, his study also adjusted returns for risk —exposure to size, value and momentum effects.
Wermers’ findings were very consistent with the results of previous studies. The following summarizes his findings:
• On a risk-adjusted basis the stocks active managers selected outperformed their benchmark by 0.7% per annum. In 13 of the 20 years encompassed by the study, active managers outperformed the S & P 500 Index. Outperforming the market is a zero sum game—if there are winners, there must be losers. Wermers’ findings are consistent with the findings of studies by Brad Barber and Terrance Odean. Their studies on the behavior and performance of individual investors found that the stocks individuals buy underperform the ones they sell. It seems that professional active managers are exploiting the mistakes of individual investors.
• The 0.7% advantage provided by stock selection skills (exploiting the mistakes of individual investors) was more than offset by expenses incurred in the effort. These expenses included bid/offer spreads, commissions, market impact costs, operating expenses and the drag of cash or fixed income investments (which underperform the market).
Wermers’ study found that the returns of active managers were reduced by approximately:
• 0.7% per annum due to holding non-equity assets. Active managers generally hold some amount of cash (or cash equivalents) in attempts to time the market, while waiting to find what they perceive to be an undervalued security, or as reserves to meet shareholder redemptions. Some managers even hold longer term fixed income investments in an attempt to outperform equities.
• 0.8% due to fund operating expenses.
• 0.8% due to transactions costs (bid/offer spreads, commissions, and market impact).
The total negative impact of expenses was 2.3% per annum.


Wow, thanks for the thorough response! As a total newcomer, why does anyone still actively manage? When I apply EMH type reasoning to this dilemma, it seems strange that active managers are so popular. Perhaps there is some benefit that we are not considering?
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Re: A new post on my blog on why hedge funds have failed

Postby nedsaid » Sat Mar 23, 2013 10:30 pm

I remember reading a book on the New York Yankees by knuckleballer Jim Boutin, I think it was called Foul Ball. He made a statement in the book that has stuck with me.

"By the time I get to where it is at, it has moved somewhere else."

This brilliant statement really sums up Larry's article on hedge funds. It is rarely a good idea to chase brand new and complicated investment strategies.
A fool and his money are good for business.
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Re: A new post on my blog on why hedge funds have failed

Postby larryswedroe » Sat Mar 23, 2013 11:45 pm

illuminate
Why do people still use active management?

1) The education system failed them, so they don't know the evidence
2) Wall Street and the media, which is where they get their information, both fail them because they need them to believe in active management because that is the winning strategy for them
3)hope triumphs over wisdom and experience

Just my personal opinions

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Re: A new post on my blog on why hedge funds have failed

Postby afan » Sun Mar 24, 2013 5:20 pm

I am too cheap to buy Bernstein's book, so I hope someone who has it can explain how they handled the data to come up with an annual alpha of 9%. The best study I have seen of the effect of reporting biases in hedge fund database returns concludes that essentially ALL of the apparent alpha was due to a series of reporting biases. (see Out of the dark: Hedge fund reporting biases and commercial databases, Adam L. Aiken, et al, http://d3gjvvs65ernan.cloudfront.net/Hedge.USA.pdf)

Once they accounted for the poor performance of funds once they stopped reporting to databases (but investors' money was still in the funds), the apparent alpha disappeared. Since they, and others, studied hedge fund returns over the same time period as Bernstein, one suspects that the hedge fund alpha reported is before accounting for these biases.

Some, with biased data, have shown an average hedge fund RETURN of 9% (which trailed the S&P 500, but with a low beta), but nothing close to an ALPHA that high.

On the other hand, the databases have been trying to improve their accuracy. In the past, for example, hedge fund managers could put request that the entire history of a fund be removed (presumably when it became inconvenient). As more of these poor returns remain in the database, the apparent average performance goes down.

An alternate interpretation of the result of declining alpha is that the mean return of hedge funds has not changed, but the reported returns are becoming less biased, and so less overestimate the performance.

In short, it is doubtful that hedge funds, as a whole, ever provided anything close to 9% annual alpha. Zero is a more likely figure.
"We don't know how to beat the market on a risk-adjusted basis, and we don't know anyone that does know either."

--Larry Swedroe
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Re: A new post on my blog on why hedge funds have failed

Postby larryswedroe » Sun Mar 24, 2013 6:33 pm

Afan
Yes there are biases in some of the databases, which is why I use the HFRX indices when I run comparisons.

AT any rate, even if the biases exist, then we still see declining alpha. The biases have been estimated at if memory serves of between 3-6%

Best wishes
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Re: A new post on my blog on why hedge funds have failed

Postby afan » Tue Mar 26, 2013 11:09 am

I am still not sure about declining alpha for the hedge fund industry as a whole, or about positive alpha during some golden age. Aiken, et al, "Out of the Dark: Hedge Fund Reporting Biases and Commercial Databases" studied problems arising from the voluntary reporting of hedge fund returns. Since each manager decides whether and when to start reporting returns to databases, which databases to which to report, and whether to continue, the sample of fund information available in the databases is heavily biased.

HFRX deals with backfill bias by only including returns of funds once they have started reporting. So wonderful results achieved before reporting began do not count. However, HFRX cannot track what happened to investments in funds that stop reporting. Using several ingenious approaches, researchers have tried to estimate the returns of funds that stopped reporting. They find very poor returns. Often investors are held in extended lock up periods, and the final liquidation value of the funds is far below the performance they had while still reporting. Thus, the returns to the industry may be much worse than one would think by looking only at the performance reported in the databases. In the Aiken paper this effect alone reduced annual alpha by over 4%. This is in addition to backfill bias, and in addition to the sort of survivor bias that could be detected by looking at database returns alone.

This makes it difficult to find positive alpha for the industry as a whole. I definitely do not know, and have not seen data that would permit one to tell, but I suspect this declining apparent alpha has more to do with databases that are more representative of actual industry performance than with actually poorer results. As noted, it would be very difficult to get the data needed to know the overall industry performance (as opposed to reported performance) or whether this had changed over time.
"We don't know how to beat the market on a risk-adjusted basis, and we don't know anyone that does know either."

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