WHAT’S THE ALTERNATIVE?

Ben Bernanke’s gambit has succeeded. Bringing interest rates through the floor, he left investors with no alternative, forcing them into equities, hoping to create a wealth effect to fuel consumer spending. He may have gone too far as the WSJ reports (my emphasis):

Individual investors are pouring tens of billions of dollars into a new generation of complex investment products, and regulators are raising concerns that not all buyers understand the costs and risks. (…)

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A total of $59 billion poured into alternative mutual funds this year through July, according to Morningstar, making it by far the fastest-growing mutual fund category. (…)

The jump in those seven months was bigger than any previous full-year increase. The alternative mutual funds attracted $25.6 billion in additional assets in 2012. (…)

The number of alternative mutual funds has grown to 402 from 77 in 2003, and assets soared to $216.47 billion as of July from $11.2 billion at the end of 2003, according to Morningstar. (…)

Part of the surge in popularity of such investments is due to a push by hedge-fund firms and buyout groups to offer new retail products as part of a search for new growth as sales to their traditional institutional clients slows, according to a report last year by McKinsey & Co.

Why that push into retail?

Hedge funds have a performance problem. Since the turn of the decade, Wall Street’s master stock pickers have spectacularly failed to beat the market.

The crisis of performance comes as the industry is under intense scrutiny over the source of past returns, with SAC Capital facing criminal insider trading charges that threaten to undermine the record of one of the world’s most successful hedge funds. The firm says it has done nothing wrong.

Since January 2010 the average equity hedge fund has produced profits for its investors, after fees, of just 14.5 per cent, according to the research group HFR.

Over the same period an investor in the S&P 500 earned, with dividends, a 55 per cent return: a total which 85 per cent of equity hedge funds have failed to match, finds HFR. (…)

The comparison may be unfair to some funds which do not aim to beat the market. Some within the industry argue that hedge funds are behaving as they should, performing better as markets plunge, but lagging behind as they steadily rise. (…)

This idea that hedge funds protect investors, and just almost everybody, from down markets, even from financial crisis, is not supported by facts.

In a 2005 article published in the Financial Analysts Journal, Princeton U. professor of economics Burton Malkiel, after analysing hedge funds returns since 1995, concluded

(…) that the practice of voluntary reporting and the backfilling of only favorable past results can cause returns calculated from hedge fund databases to be biased upward. Moreover, the considerable attrition that characterizes the hedge fund industry results in substantial survivorship
bias in the returns of indices composed of only currently existing funds.

Correcting for such biases, we found that hedge funds have returns lower than commonly supposed. Moreover, although the funds tend to exhibit
low correlations with general equity indices—and, therefore, are excellent diversifiers—hedge funds are extremely risky along another dimension: The cross-sectional variation and the range of individual hedge fund returns are far greater than they are for traditional asset classes. Investors in hedge funds take on a substantial risk of selecting a dismally
performing fund or, worse, a failing one.

The Economist provided more up-to-date data in a Dec. 2012 article titled Going nowhere fast:

The S&P 500 has now outperformed its hedge-fund rival for ten straight years, with the exception of 2008 when both fell sharply. A simple-minded investment portfolio—60% of it in shares and the rest in sovereign bonds—has delivered returns of more than 90% over the past decade, compared with a meagre 17% after fees for hedge funds. As a group, the supposed sorcerers of the financial world have returned less than inflation. Gallingly, the profits passed on to their investors are almost certainly lower than the fees creamed off by the managers themselves.

The WSJ looks at returns since the beginning of the financial crisis:

Yet the poor performance of the last three years now far outweighs hedge funds’ resilience through the worst of the crisis. Over the past five years the S&P 500 with dividends has delivered average annual returns of 7 per cent, while equity hedge funds have produced just 1.7 per cent, according to HFR.

But it goes beyond performance numbers. The hedge fund industry is so large and so powerful with brokers, banks and politicians that it now has a huge economic and financial impact. Scott Patterson’s “The Quants” is a good read on that. The industry has recently successfully lobbied to get access to smaller investors just when the larger ones are finally discovering the real “truth”.

Adding to some of the regulatory worries was the Securities and Exchange Commission’s decision in July, in response to legislation passed by Congress, to permit hedge funds to advertise for the first time, which could increase the visibility of the products.

And now:

Heath Abshure, Arkansas’s securities commissioner and president of the North American Securities Administrators Association, said alternative investments are “one of our biggest investment problems, and all our members are looking at them.”

The Economist suggest alternatives to alternative investments…

Defenders of the industry maintain that even a small allocation to hedge funds can diversify a portfolio away from turbulent markets. Perhaps, but long-term institutional investors should be well-placed to ride out market turmoil. And there are other ways to diversify. Exchange-traded funds allow investors to gain exposure to anything from gold to property to Indonesian firms, and they charge investors just a few basis points (hundredths of a percentage point) on the money they put in. That compares with fees of 2% of assets and 20% of profits (above a certain level) typically charged by hedge funds. In a low-interest-rate environment, where returns are unlikely to hit double digits, a 2% annual management charge seems particularly steep. Institutions have put pressure on fees, but with only mixed success so far.

The hedge-fund industry’s trump card is that a handful among them have delivered stellar returns over the long term. But the same is true of any sort of investment.

…agreeing with Malkiel:

The average hedge fund is a lousy bet, and predicting which will thrive and which will disappoint is a task that would tax even a Nobel prizewinner.

To finish dispelling the myth around hedge fund managers, Jon Sundt, President & CEO of Altegris Advisors, hits on two characteristics of hedge fund returns: high dispersion and attrition rates in a recent note titled “All Managers Are Not Created Equal”

The accompanying chart compares performance dispersion of traditional, long-only mutual funds invested in large cap value stocks with three types of alternatives investments—managed futures funds,
long/short equity hedge funds and global macro hedge funds. (…)

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To illustrate the importance of performance dispersion among
alternative investments, compare the dispersion of the large cap mutual funds with long/short equity hedge funds in 2012. As the chart shows, in 2012, large cap value mutual funds all performed relatively similarly. The bottom 25% gained an average of 10.68%, while the top 25% gained 18.57%. The dispersion was less than 8%. (…)

By contrast, long/short equity hedge funds had a much wider range of performance. The bottom 25% lost 6.94% while the top 25% gained 26.12%. The dispersion was 33%. (…)

(…) Picking the right manager matters immensely where dispersion is high. It’s a similar phenomenon with managed futures and global macro funds. In both cases, the performance dispersion was also greater than for large cap value mutual funds.

Dispersion shows the range of results of existing managers but it omits the results for managers who have left the business, resulting in what statistics experts call “survivor bias.”

Performance dispersion tells only part of the story. Attrition tells another part. Figure 3 shows the attrition rate for managed futures funds. When the number of “attrited”—or dissolved—programs are added to the picture, the risks of picking an underperforming manager become more clear.

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Thus, even though 2008 was a stellar year for managed futures—they gained 15.4% versus the S&P 500 TR’s 37% loss—more than 20% (166 dissolved out of a total of 772 programs) of the managers dissolved their funds.

In other words, despite being a winning strategy in 2008, it was possible for managed futures funds to lose money. The year 2012 further illustrates the importance of manager selection. As Figure 3 shows,
the number of managed futures programs declined by 30% in 2012.

Understand that many return stats published on the hedge fund industry omit many or all the “attrited” losers. Since 2008, there have been 376 new “managed futures funds” while 700 were dissolved. The birth/death rate trend for other types of hedge fund is likely similar.

Hedge funds as an asset class? Only if you can find the right managers. And then hope that they have class!

 

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