Chapter Eight
So Why Invest in Hedge Funds?
Okay, We Lied
If all of the previous so-called myths are valid reasons to be wary of investing in hedge funds, there must be some pretty good arguments on the other side to explain why professional investors stand by them. Pensions, institutions, endowments, and tax-exempt organizations use hedge funds for anywhere from 10 to 25 percent (depending on which study you read) of their investment allocation, while retail investors like us—who also would like to make a dollar if we could—have close to zero percent in the game. What’s an investor to do?
Okay, we’re going to tell you.
But before we do, we have to come clean. First, we admit that hedge funds in aggregate are probably not going to “beat the market.” Any given year, some funds will beat the stock market by a spectacular amount. Over time, however, many funds may not.
Second, let’s accept that we are not going to be able to gain access to these strategies for the same price as a Vanguard index fund. These are specialized approaches requiring more brainpower to work and more expense to operate, and we are going to have to pay for them.
Third, let’s grant that hedge funds have a moderate correlation to regular market indexes. They are not an insurance policy with a guarantee to save us when the market is down.
Hark back to the thrilling days of yesteryear. Remember the credit crisis, when the S&P 500 lost 37 percent of its value in 2008? We do. We still wear the lash marks on our backs. How did hedge funds perform during this period? As you may have heard, they were down a lot as well, about 15 to 19 percent. Certainly a big disappointment to anyone who expected hedge funds to be uncorrelated to the stock market, or who expected them to be up when everything else was coming down. But then, being down 19 percent is better than being down 37 percent.
We mentioned how 2000 to 2009 was called the lost decade for the stock market, which had an annualized return of minus 1 percent over the entire span. Hedge funds had annualized returns ranging from 4 to 7 percent over the same decade.
Gentle reader, hedge fund strategies could be the missing third leg to the stool you are sitting on that is supported by stocks and bonds. While the strategies are miles away from being perfect, they probably represent a meaningful improvement over what you are doing at present. After all, they offer positive expected returns with only moderate correlations to your current holdings. They offer a path to increase your risk-adjusted returns, which means that by using them, you stand to accumulate greater wealth from your investments over time.
Hedge fund strategies could be the missing third leg to the stool you are sitting on that is supported by stocks and bonds.
What’s more, because these strategies are less correlated to the stock market, they are less correlated to the rest of your life: your job, your 401(k), your house. They should help—at least relatively—when everything else is riding three cars behind the flowers. Having a meaningful portion of your assets bet on things that aren’t disintegrating will help you to stay calm and carry on.
Sometimes people think that using alternative investments such as hedge funds will eliminate risk. That isn’t so. Alternative investments simply substitute different risks that pop up in different ways at different times. The effect, however, is that the overall volatility of our portfolios should be lowered. We will be taking more jabs to the body instead of the big haymaker to the skull.
Reality has sharp teeth. Risk means that you can lose money. That’s why it’s called “risk” and not an ice cream sundae. Just as teenage boys are taught that “No means No,” adults need to remember that “risk means risk.”
Reality has sharp teeth. Risk means that you can lose money. That’s why it’s called “risk” and not an ice cream sundae.
So, where can we find these investments?
The good news is that hedge funds are going downmarket and coming to a town near you. Greenwich is moving to Main Street.
Essentially, the hedge fund industry has reached the point that the automobile industry arrived at 100 years ago, when Henry Ford put cars onto an assembly line. Cars went from being handmade, one-off products for the elite to mass-produced Model Ts for everyman. The result was a more reliable product, albeit one with less snob appeal.
So, too, with hedge funds. The guts of the hedge funds have been extracted, their DNA has been analyzed and synthesized into the same mutual fund format that retail investors are already familiar with.
The mutual fund format offers tremendous advantages:
- Lower expense ratios
- No performance fees
- Low investment minimums
- Simplified tax reporting
- Daily liquidity
- Daily pricing
- Transparency
- SEC Regulation
- Less leverage
All of which means less risk.
The hedge funds that we read about in the Wall Street Journal are outliers: Either they have scored such impressive returns that they merit a headline, or else they are the ones whose directors are being hauled off to prison. Most hedge funds are not so newsworthy. While they have the high-flying image of risky investments, their whole point is actually to reduce risk when used in combination with conventional stock and bond portfolios. They are a strategy of singles, not home runs.
The mutual funds based on hedge fund strategies are new and may feel uncomfortable for that reason, but there is no Bernie Madoff behind the curtain who is going to steal our money. Mutual funds lack that special combination of high leverage and illiquid positions that go to creating a financial Death Star. While the lay perception is that you invest in hedge funds to get rich, for the most part hedge funds have only moderate returns. It’s their relatively low correlation to stocks and bonds that lets them add feng shui to the rest of your portfolio.
Of course, as hedge funds have shape-shifted into mutual funds, something is lost in the translation. We have forfeited the possibility of stumbling onto the guy who sees the subprime crisis coming and shorts it and makes us a zillionaire. Alpha managers like that would want to run a true hedge fund where there was an incentive fee to reward their genius. They wouldn’t want to work for a boring conventional mutual fund where performance fees are disallowed.
Like the search for the Lost Dutchman mine or the golden city of El Dorado, the quest for this magic manager has led many investors to ruin, and the sooner we give up looking for him the better off we will be. While we would all love to tap into the bliss of finding a true hedge fund superstar, picking the right manager at the right time, that is not our sport. Instead of dreaming of perfect love, the best answer for most of us is to lower our sights to something more achievable: the returns available from running the generic core of each hedge fund strategy.
From Bogle to Boggle
Let’s brush up on some Greek:
- Alpha—The extra returns we get from hiring skillful or lucky managers, above and beyond what we could have obtained by investing in an index fund that passively owns the whole market. When we’re talking about stocks, an alpha manager is one who beats the S&P 500 index. Unfortunately, there seem to be very few of those chaps around. We always seem to find them just when their hot hand turns cold, which suggests that they weren’t unusually skillful to begin with, just lucky for a while.
Because alpha is so rare, we are not going to bother much with it. However, that will not stop us from stretching the term to refer to any excess returns we can scrounge out. For example, we will say things like, “From the point of view of the vanilla stock and bond investor, alternative investments can add alpha.”
- Beta—The extent that an individual investment responds to swings in the larger market. We are going to use it here to refer to the risks and returns that flow from any specifiable investment strategy. For example, you can access the beta of the stock market by buying an S&P 500 index fund. Since risk and reward are related, you get the standard payout that comes from bearing that standard risk. You buy the stock market, and you get the returns proportionate to owning the market “beta.” If you own a portfolio of high beta stocks, you get the risks and returns of the market amplified to that degree. If there is a strategy common to most managers who are running a particular type of hedge fund, we will call this the source of the hedge fund’s beta. We are going to casually say things like, “From the point of view of the vanilla stock and bond investor, following hedge fund beta strategies can add alpha.”
- Ouroboros—A mythical snake that bites its own tail, consuming itself. A word with which you may not be generally familiar. It has nothing to do with finance, but we’re going to sneak it into this book anyhow. Watch for it.
- Quant—Someone with a Ph.D. in finance from M.I.T. or the University of Chicago. Quants look at the markets abstractly, through the lens of statistical models, and then engineer sophisticated trading strategies (often) using high-powered computers. See also, “Billionaire.”
The History of Finance in One E-Z Lesson
Now that we’ve learned these terms, it’s time to start bruiting them about. Since we’d probably get caught if we tried to pass off the following ideas as our own, we might as well admit we cribbed them from AQR Capital’s white paper, “Is Alpha Just Beta Waiting to Be Discovered?” Here’s a CliffsNotes version (with apologies to Cliff Asness, AQR’s head). Hang on to your hat, because it explains the genesis of the alternative investments we are going to be considering throughout the rest of the book.
Financial history illustrates that what we once thought of as excess returns—alpha—has often just turned out to be some investment strategy people were following that had a hidden logic and worked but was not well understood or widely known at the time. Eventually, though, people began to catch on and the formula got out.
In the 1950s and 1960s, if you were a stock market investor, you probably would have held a portfolio of individual stocks that a broker had recommended to you. Everything you earned from this approach could be attributed to your broker’s stock picking skill.
Then, with the advance of finance theory and the implementation of index funds, a much tougher bogey emerged. You could separate your stockbroker’s performance from that of the market as a whole. A lot of what before had looked like his pure skill could be attributed to the general performance of the stock market. The market was up, he was up. The market was down, he was down.
It gradually dawned on investors that, after expenses, just owning a low-expense, tax-efficient fund that contained every stock in the S&P 500 index was a better way to capture whatever there was to be had from stock market investing. Few stock pickers could beat this index, and no one could tell in advance who they would be. In effect, the stockbrokers’ “alpha” had turned into everyday, ordinary “beta” that anyone could get just by buying and holding the whole market.
As academic research into stock market performance continued, alpha retreated further. Certain market anomalies cropped up: Value stocks beat the market, small company stocks beat the market, and low beta stocks performed better than they should for their risks. Managers who specialized in these investing areas naturally outperformed. But then these styles, too were reduced to quantifiable formulae and applied systematically. The alpha managers who survived the indexing cut now had the rug pulled out from under them. Once these style factors were corrected for, there seemed to be precious little alpha left anywhere in the stock market. The quants had fed all the stock market data into their computers and transformed the alpha into beta.
Exiled from the garden, portfolio managers were driven to new pastures in pursuit of alpha gold, but the mathematicians were close at their heels. Almost immediately, the quants turned their sights on to commodities, real estate investment trusts, and emerging market stocks, transforming these exotic alphas into beta.
That is the relentless Hegelian dialectic of investing history: The lawn mower of progress chews up alpha and spits out beta. What first looks like magic turns out to be nothing more than returns that are available by following some specifiable investment methodology. If you don’t know the trick, it’s alpha. Once you know the trick, it’s beta.
The relentless Hegelian dialectic of investing history: The lawn mower of progress chews up alpha and spits out beta.
Today, we stand at a new threshold. Like Ouroboros, the quants have turned the computers on themselves and started digesting their own hedge fund strategies. They have extracted the essence, bottled it into conventional mutual funds, and put them on the supermarket shelf within reach of ordinary retail mutual fund investors.
These alternative betas represent the returns we can achieve by exposing ourselves to the risks shared by hedge fund managers who are pursuing common underlying strategies. To the hedge fund managers, they are beta, but to you and me, sitting on our stocks and bonds, they look like alpha: a source of alternative, low-correlated positive returns.
Far out.
When Phil was in college in California in the 1960s, he came across a book called Cosmic Consciousness, which argued that the human race was on the verge of a breakthrough into a higher state of evolution. This finding was reinforced when he saw the mind-expanding ending of 2001: A Space Odyssey. Unfortunately, nothing much has happened since. We seem to be stuck in the same old low-consciousness place.
On the other hand, investing theory has evolved. The arrival of hedge fund beta for ordinary investors is not to be dismissed. It’s not exactly like finding a black monolith on the moon, but it is a small step forward here on the planet of the apes.
The Alternative Reality
Although most of us don’t have access to real hedge funds, “lite” versions of their basic strategies are now being packaged inside mutual funds. This represents a giant step forward in the history of investing. Or, maybe it’s all hype. We shall see.