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S&P has outperformed its hedge-fund rival for ten straight years.


PlanMaestro
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If hedge funds underperform, mutual funds underperform, and retail investors underperform ... who performs?

 

 

None in aggregate and in the long run - notable subgroups who I think are the exception are proprietary traders with benefit of front running/insider trading and Grahamites.

 

Index investors get the market return, all others get market return less fund expenses (transaction costs, fund fees, taxes, etc). So the total return for all active investors must by definition be less than the market.

 

Vinod

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Agree Vinod, but don't you find strange a level of hedge fund underperformance that is way more that could be justified by fees and transactions costs? And studies of retail investors buy high / sell low of mutual funds underperformance is in the hundreds of bps per year over the manager underperformance. Who is picking this performance, just hedge fund managers' 2/20?

 

None in aggregate and in the long run - notable subgroups who I think are the exception are proprietary traders with benefit of front running/insider trading and Grahamites.

 

Index investors get the market return, all others get market return less fund expenses (transaction costs, fund fees, taxes, etc). So the total return for all active investors must by definition be less than the market.

 

Vinod

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Guest hellsten

Thanks. Interesting article. I wonder what the main reasons for underperformance are?

 

First thought is stupidity, but that's not the reason :) Overconfidence in their abilities to beat the market is definitely one reason:

John Paulson, celebrated as an investment wizard in 2007 for having foreseen America’s housing bubble, reportedly saw his flagship fund lose 17% in the first ten months of 2012, after a 51% fall in 2011.

 

Justifications for poor performance are as diverse as hedge funds themselves. Mr Paulson seems to be blaming his malaise on a bet that Europe would falter.

 

Size is another factor:

Another reason is size. Hedge funds now manage $2.2 trillion in assets, up fourfold since 2000. Because individual trades can absorb only so much cash, the effect of all that new money is to push funds to take second-rate bets that would have been considered marginal in the past. “At $1 trillion of assets under management hedge funds delivered acceptable returns,” says Mr Lack. “Less so at $2 trillion.”

 

Too many amateurs, or criminals as I prefer to call them, entering the field is probably another:

http://www.hedgefundfacts.org/hedge/statistics/number-of-funds/

 

Can't blame them. >2% fees is legal theft. And it's easy to beat the market, right? :)

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Hedge fund industry loses out again

http://www.ft.com/intl/cms/s/0/3fa68bda-4b7f-11e2-887b-00144feab49a.html#axzz2Glh78llf

 

According to Hedge Fund Research, slight gains in December were likely to mean the average hedge fund manager made just more than 5 per cent over the year – a period watched closely by many investors after disappointing returns in 2011, when the average hedge fund lost 5 per cent.

 

As with 2011, the eurozone crisis dominated most funds’ trading. Global macro funds, which aim to profit from shifts in economic sentiment, were among the hardest hit, entering a second year of losses for investors.

 

Some of the strategy’s most prominent players eked out low returns. Paul Tudor Jones’ flagship fund made just more than 5.2 per cent in the year to mid-December, according to an investor.

Brevan Howard, Europe’s largest macro hedge fund, made 3 per cent, while Caxton Associates, another prominent group, lost 3.4 per cent in the year to November.

 

Bearish managers fared worst, as the eurozone avoided a costly break-up even though it fell back into recession in 2012. Comac, a London-based macro hedge fund, was down 8.9 per cent for the year in mid-November.

 

So-called “tail risk” funds, which aim to profit in times of market dislocation, also suffered. The $2bn Capula tail risk fund, the world’s largest so-called “black swan” trader, had lost 14 per cent by November.

 

Other notable losses for the year included those of John Paulson, the hedge fund manager who made billions shorting US subprime mortgages in 2007. Mr Paulson’s flagship Advantage Plus fund lost more than 20 per cent in 2012, compounding losses of more than 50 per cent the previous year.

 

 

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Agree Vinod, but don't you find strange a level of hedge fund underperformance that is way more that could be justified by fees and transactions costs? And studies of retail investors buy high / sell low of mutual funds underperformance is in the hundreds of bps per year over the manager underperformance. Who is picking this performance, just hedge fund managers' 2/20?

 

Not really. I think most hedge funds operate to shoot the lights out, leveraging to the hilt due to the incentive structure of 2/20. If they blow up, they start anew. So in any period where a black swan type event shows up, hedge funds under perform. On the other hand when everything goes well they outperform. This is just another version of "Dunn's law of mutual fund performance" applied to hedge funds.

 

Dunn's Law states that “When an asset class does relatively well, an index fund in the asset class does even better. In contrast, when an asset class does poorly, the active managers do better in that asset class.”

 

http://www.efficientfrontier.com/ef/400/dlr.htm

 

Vinod

 

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To be fair to a lot of hedge funds that are not 100% net long, because they have some short positions, they are expected to underperform in a market that goes straight up. However, it is very concerning when some of the funds that are levered long end up underperforming in an up market. If I remember correctly, Paulson was making a pretty big bet on a US recovery a while back and he got killed on BAC and C, and he seemed to have gotten out right when those two stocks bottomed and now his original thesis is actually playing out. His Advantage Plus fund is down about 60% in two years when the market is up about 25%. People who got in 2 years ago have $0.40 instead of $1.25, there is almost no realistic compound rate where they will ever make their money back. Investors should also raise their eyebrows when the black swan or tail risk funds lose 10-15% in one year. That is some really expensive insurance if you are trying to protect against a once every 20-30 year event.

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