Hedge fund managers are arguably considered as the messiahs of money. There is an overwhelming assumption that such managers are the crème-de-la-crème of financial genius – this is far from the truth.
Ask someone who’s been involved with these managers for several years or someone who’s researched the performance of these very managers, and you will come to a remarkably different conclusion.
In 1974, Burton Malkiel, a Princeton University professor, claimed – amusingly – that a blindfolded monkey randomly throwing darts at a financial newspaper, could perform just as well as investment managers[1]. Many years later, he was proven wrong – dart throwing monkeys actually performed better[2].
To add some weight to the failure of hedge fund managers, let’s take a look at recent industry performance:
In 2015, it was reported that 66% of clients were unhappy with their hedge fund’s performance; now the dissatisfaction rate stands at 75%[3].
Over the past 5 years, hedge funds have yielded just a 1.7% annualized return, while the S&P 500 has yielded 11%[4]. Stretching the time frame, over the last 10 years, hedge funds have only managed to return 3.4% for their clients[5].
So what are the factors that have caused such poor performance in the hedge fund industry?
Risk-Adjusted Returns
Many hedge funds claim that their returns are better risk-adjusted. You can invest in a generic index fund – which is not managed and follows an index – for better performance. But they are not adequately adjusted for downside risk, or in layman’s terms, they do not minimize losses.
Lack of Originality
Some critics have outlined the lack of diversity in the hedge funds, as a serious problem. Not racial, or gender diversity, but the diversity of ideas. Most hedge funds simply try to emulate ideas previously created by other successful hedge funds. This makes sure everyone is looking in the same direction; so when a good opportunity arises elsewhere, no one is looking.
“that there’s so many players out there trying to do similar strategies …” – Steve Cohen of formerly SAC Capital[6]
Herd Mentality and Other Cultural Problems
Groupthink, peer pressure, and herd mentality. The world of finance is hardly oblivious to it[7][8][9].
Successful Hedge Funds like Bridgewater Associates, actively try to eliminate such problems by having a unique confrontational culture[10]. Everyone can be questioned or critiqued – to find ‘universal truths’ – and there is radical transparency – all the meetings are recorded, so you cannot back out or blame someone else. Unfortunately, a confrontational culture doesn’t agree with everyone; although it is apparent that such a culture might be necessary for hedge funds – to eliminate herd mentality issues.
The Rise Of The Idealists
The few hedge funds that have been successful in the past, have been so because they were run by brilliant contrarians. The hedge fund industry is meant for such individuals; the problem is all managers think they have these required qualities, and others are simply joining the industry for greed.
To elaborate, in 1990 there were just 610 hedge funds managing less than $40 billion[11], today there are almost 8500 hedge funds managing over $2 trillion[12]. Fittingly, for the entire 1990’s hedge funds returned 18.3% annually, as the number of hedge funds increased, the overall industry performance decreased. We witnessed an increase in lackluster hedge funds, which grew because of greed and over-optimism.
Clearly, the opportunities are far too few, and the managers are far too many. This is a simple problem of oversupply, in addition to the behavioral errors (over-optimism) of the managers.
For the Hedge Fund industry to regain their lost status of elite super-investors, who achieved 18.3% annualized returns, we have to wait for the bad firms to go out of business, or witness a pricing overhaul where lower fees make the industry more attractive.
[1] https://www.forbes.com/sites/rickferri/2012/12/20/any-monkey-can-beat-the-market/#48e64a15630a
[2] https://www.forbes.com/sites/rickferri/2012/12/20/any-monkey-can-beat-the-market/#48e64a15630a
[3] https://www.ft.com/content/4b727f0a-f2dd-11e6-95ee-f14e55513608?mhq5j=e2
[4] http://money.cnn.com/2016/05/18/investing/hedge-fund-golden-age-over-fees/index.html
[5] https://www.bloomberg.com/gadfly/articles/2016-03-24/hedge-funds-have-a-performance-problem
[6] http://www.theaustralian.com.au/news/world/the-times/hedge-funds-risk-washout-from-herd-mentality/news-story/40ff9c837a5daedd07d7728667ef9e8a
[7] https://www.bloomberg.com/news/articles/2017-02-21/hedge-fund-liquidity-falls-to-danger-zone-in-u-s-stock-market
[8] https://www.thetimes.co.uk/article/herd-mentality-is-leading-hedge-fund-managers-closer-to-danger-nxqqmwlst
[9] https://www.bloomberg.com/news/articles/2017-02-21/hedge-funds-continue-to-chase-the-herd-in-record-momentum-wager
[10] http://www.businessinsider.com/ray-dalio-management-strategy-bridgewater-2016-1?IR=T
[11] https://www.bloomberg.com/gadfly/articles/2016-03-24/hedge-funds-have-a-performance-problem
[12] https://www.ft.com/content/9bd1150e-1b76-11e6-b286-cddde55ca122?mhq5j=e2
