From Vern Gowdie – Daily Reckoning (Australia) –
Nothing like a run of bad economic news to make the US share market move into positive territory.
Since 2008 it’s been a case of ‘good news, market down’ and ‘bad news, market up’.
If this warped logic prevails, a collapse in the US economy should send the Dow soaring through the 20,000-point barrier and beyond.
Last Friday there was the lower than expected US nonfarm payroll data. Overnight, the Institute of Supply Management (ISM) non-manufacturing (services) index tumbled to its lowest reading since February 2010.
In true Monty Python form, the US market’s Black Knight simply shrugs off the continuing soft data as ‘a flesh wound’.
The weak data means the Fed is unlikely to increase interest rates. Gee, what a surprise…
The disconnect between the underlying economy and the markets continue…for now.
The RBA kept rates on hold yesterday. But with only one hammer in the monetary toolbox, the interest rate nail is going to be driven down further in the coming months.
‘Make money cheaper and screw savers’ is the other bit of warped logic we’ve had to endure since the collapse of Lehman Brothers in September 2008.
The gold price has risen strongly on the poor data…catching the masters of the universe off-guard. According to Mining.com:
‘Large scale gold futures and options speculators or “managed money” investors such as hedge funds were wrong-footed by the negative employment and wage numbers and had been positioning themselves for further declines in the gold price ahead of the[Department] of Labor data.’
This ‘wrong-footed’ approach is more common than you think.
Which begs the question: Why do hedge funds enjoy such mythical status in the investing world?
It’s to do with how we are wired.
The swashbuckling batsmen. The athletic brilliance in the field. Bowlers threatening to splinter the stumps. 20/20 cricket excites the crowd.
Cricketers earn serious money these days from the much shorter version of the game.
Cricket authorities, in recognition that society’s attention span does not extend beyond 140 characters, have made the commercial decision to adapt the grand game of cricket to modern day lifestyles.
Test matches — five days of cricketing chess play — are on the wane. Boring.
We are wired for excitement.
The proliferation of hedge funds indicates the need for constant stimulation is very much alive and well in the world of investing.
It’s estimated that, in the US alone, there are over 11,000 hedge funds — that’s 11,000 funds earning (or more like charging) 2% management and 20% bonus fees for performance above an arbitrarily determined ‘hurdle’ rate.
According to the hype (sorry, marketing), hedge funds — thanks to the investment professionals’ astute assessment of the markets and the ability to go long or short – can deliver investors superior results. The label ‘absolute return funds’ is often bandied about to create the impression that’s what investors are destined to achieve.
So how did these funds go in 2015? According to an article published by CNBC in January 2016 titled ‘The hedge fund managers that made it big in 2015’ (emphasis mine):
‘The top 20 managers together made $15 billion net of fees for their investors in 2015 and outperformed the hedge fund performance averages by a considerable margin, according to new data published by LCH Investments… Hedge fund managers outside the top 20collectively lost some $99 billion for their investors, the research shows.’
That’s impressively bad — 99.8% of the funds collectively lost US$99 billion.
What’s even more impressive is how much they got paid for losing money.
There’s around US$3 trillion of investor money in US hedge funds. Apply the standard 2% management charge to this figure and you come up with US$60 billion in management fees. In addition to the base management charge (sorry, fee), if the funds managed to outperform a pretty low ‘hurdle’ rate, they picked 20% of the ‘outperformance’.
Just how well paid are the top performing hedge fund managers? In May 2016, The Guardian reported (emphasis mine):
‘Top 25 hedge fund managers earned $13bn in 2015 — more than some nations Top earners, Kenneth Griffin and James Simons, made $1.7bn each despite “hedge fund killing field” on Wall Street where many companies lost billions or closed.’
Far be it from me to begrudge these guys the opportunity to earn a decent dollar, but US$1.7 billion for a year’s work?
The reason I ask the question with a raised eyebrow is due to a report I read recently from Dominique Dassault — a 26-year veteran of the private equity and hedge fund industry.
According to Dassault, all these ‘black box’ trading systems BLOW UP.
When he asked an esteemed portfolio manager: ‘Why do they all “BLOW UP”? What are those common traits that seem to effect just about every quantitative model despite the intellectual and capital fire-power behind them? And if they all eventually “BLOW UP” then why are we even doing this?’
The reply from the esteemed portfolio manager was: ‘We are all doing this because we can make a lot of money BEFORE they “BLOW UP”. And after they do “BLOW-UP” nobody can take the money back from us.’
Got that? Make a truckload this year and blow up the fund next year. The manager walks away while the investors are left in the wreckage. Great attitude.
When Dassault asked why the systems inevitably ‘blow up’, he was told:
‘Because despite what we all want to believe about our own intellectual unique-ness, at its core, we are all doing the same thing. And when that occurs a lot of trades get too crowded…and when we all want to liquidate [these similar trades] at the same time…that’s when it gets very ugly.’
The reality is that professionals are just as guilty of herding as the rest of us. They extrapolate trends into the future and invest accordingly.
For the record, not all hedge funds are run by selfish, fee grabbing egotists.
I have some very good friends who manage hedge funds. They are seriously smart and committed to delivering value for money. They have substantial ‘skin in the game’ — meaning their own wealth is invested in their fund. Their interests are aligned with the investors.
Unfortunately, this is the minority.
My observation is that greed has been the compost behind the mushroom-like sprouting of hedge funds.
Greed by investors. Greed by managers.
A recent conversation with an investment banker gave me an insight into the industry’s thinking. His ambition is to start up a hedge fund. Why? Once you get more than $500 million in the fund, you can ‘gate the fund’ (close it to redemptions for a period of time) and make a cool $10 million a year plus bonuses.
I kid you not, that was the gist of the conversation.
How did the culture become so misguided? Because ‘everyone is doing it’.
In looking at the 2015 performance data — where 99.8% of funds collectively lost US$99 billion — he’s right on that last point.
But it takes two to tango. Greedy managers — to achieve their sole objective of making out like bandits — need investors who think/believe/wish there’s a magic investment pudding.
Obviously, there are enough investors — gauging by the US$3 trillion invested in hedge funds — who fit this profile.
No doubt some investors have been rewarded handsomely by the exceptionally talented managers. However, the majority have not been so fortunate.
In 2011, Ilia Dichev (Emory University) and Gwen Yu (Harvard University) published a research article titled: ‘Higher risk, lower returns: What hedge fund investors really earn’.
This is an extract from the paper’s abstract:
‘…Our main finding is that annualized dollar-weighted returns are on the magnitude of 3% to 7% lower than corresponding buy-and-hold fund returns. Using factor models of risk and the estimated dollar-weighted performance gap, we find that the real alpha of hedge fund investors is close to zero. In absolute terms, dollar-weighted returns are reliably lower than the return on the Standard & Poor’s (S&P) 500 index, and are only marginally higher than the risk-free rate as of the end of 2008. The combined impression from these results is that the return experience of hedge fund investors is much worse than previously thought.’
In a nutshell, hedge fund investors pay a truckload in fees to receive (at best) a barrow load of returns.
Taking the low cost, boring approach — like investing in the S&P 500 index — would have produced a far better long term result for investors.
In the investment business, boring gets you fired.
Investors (most, not all) want constant stimulation — looking for the big payday.
There’s this belief in ‘Mum & Dad Investor Land’ that there’s an alternative universe of investing — one the professionals and the wealthy have exclusive access to. Investing in hedge funds is the average punters way of being connected to the so-called smart money.
Speaking from 30 years of experience, give me boring, transparent and low fee investment options every day of the week.
I’ll leave it to others to invest in the complex, opaque, high fee ‘opportunities’.
Remember, the golden rule in investment banking is ‘the less your client knows, the more you earn’…also, the fine print ensures the client has accepted the risk they knew nothing about.
When the next, and far more devastating, market downturn hits, investors are going to realise the steady approach of taking singles and building a solid innings is far more rewarding than trying to swing for the fences.