|
|
|
|
Most hedge-fund strategies are broadly market-neutral. That is, rather than bet on a market moving one way or the other, they play the difference—arbitrage, in the argot—between markets or individual securities. Thus they buy a cheap share and sell an expensive one; or they anticipate the effect of news on the prices of an array of companies. The need for speed helps explain why hedge funds pay up to one-third of all stockbroking commissions, and account for 10-30% of trading on the London stockmarket, depending on the day. ...For many trading strategies, however, there is a limit to the amount of money that can be moved around cheaply and briskly. While punting large amounts on the highly liquid foreign-exchange or government-bond markets is easy, betting on illiquid corporate bonds or shares is far harder. And the larger the amounts, the more expensive the bets are. It is for this reason that many of the oldest and best-known hedge funds will not accept any new money. Some have even been handing capital back to investors. Vega itself had told some in the industry that it did not want to grow above $2 billion, though it now clearly has more confidence in its abilities. Whether this is justified remains to be seen. Performance in general seems to be deteriorating. In the late 1990s, says Mr St Aldwyn, no one would touch a fund that did not claim to be able to make 15% a year. Now investors seem happy with a promise of high single-digit returns. In recent years, hedge funds have been a hot topic in the financial world and up to $1 trillion has flowed into the sector. Last year, it was reported that US hedge fund manager Edward Lampert of ESL Investments, had earned earned $1 billion in 2004*. However, returns do not generally match the hype. Long-term record not impressive The focus of the research was on hedge funds, beginning with 604 in 1996 and rising to 2,700 in 2003. The funds produced an annual average return of 9.3 percent, compared with 9.4 percent for Standard & Poor's index fund. However, a key comparison feature is that hedge funds create much higher tax liability because they trade so often and have so much short-term taxable income, compared with a tax-efficient index fund. They also have far higher fees than index funds. The fees for an index fund in the US are as low as 20 basis points — two-tenths of a percentage point — of the amount invested. A hedge fund takes a fee of one to two full percentage points of net assets off the top, and 20 percent of any profits. This reduces the net hedge fund returns significantly compared with index funds. Dr. Malkiel and Dr. Saha calculated that if hedge funds earned almost 50 percent more than market returns, the higher taxes and fees that hedge funds pay would reduce their net return to investors to 20 percent less than index funds. In a conclusion to their paper, the researchers say that hedge funds are marketed as an “asset class” that provides generous returns during all stock market environments and thus serves as excellent diversification for an all-equity portfolio. The funds have attracted close to $1 trillion of investment capital.We showed 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. Warren Buffett's jaundiced view of financial Helpers In his recent letter to shareholders, in respect of 2005, the legendary investor Warren Buffett wrote the following on what he termed Helpers: Indeed, owners must earn less than their businesses earn because of “frictional” costs. And that’s my point: These costs are now being incurred in amounts that will cause shareholders to earn far less than they historically have. To understand how this toll has ballooned, imagine for a moment that all American corporations are, and always will be, owned by a single family. We’ll call them the Gotrocks. After paying taxes on dividends, this family – generation after generation – becomes richer by the aggregate amount earned by its companies. Today that amount is about $700 billion annually. Naturally, the family spends some of these dollars. But the portion it saves steadily compounds for its benefit. In the Gotrocks household everyone grows wealthier at the same pace, and all is harmonious. But let’s now assume that a few fast-talking Helpers approach the family and persuade each of its members to try to outsmart his relatives by buying certain of their holdings and selling them certain others. The Helpers – for a fee, of course – obligingly agree to handle these transactions. The Gotrocks still own all of corporate America; the trades just rearrange who owns what. So the family’s annual gain in wealth diminishes, equaling the earnings of American business minus commissions paid. The more that family members trade, the smaller their share of the pie and the larger the slice received by the Helpers. This fact is not lost upon these broker-Helpers: Activity is their friend and, in a wide variety of ways, they urge it on. After a while, most of the family members realize that they are not doing so well at this new “beatmy-brother” game. Enter another set of Helpers. These newcomers explain to each member of the Gotrocks clan that by himself he’ll never outsmart the rest of the family. The suggested cure: “Hire a manager – yes, us – and get the job done professionally.” These manager-Helpers continue to use the broker-Helpers to execute trades; the managers may even increase their activity so as to permit the brokers to prosper still more. Overall, a bigger slice of the pie now goes to the two classes of Helpers. The family’s disappointment grows. Each of its members is now employing professionals. Yet overall, the group’s finances have taken a turn for the worse. The solution? More help, of course. It arrives in the form of financial planners and institutional consultants, who weigh in to advise the Gotrocks on selecting manager-Helpers. The befuddled family welcomes this assistance. By now its members know they can pick neither the right stocks nor the right stock-pickers. Why, one might ask, should they expect success in picking the right consultant? But this question does not occur to the Gotrocks, and the consultant-Helpers certainly don’t suggest it to them. The Gotrocks, now supporting three classes of expensive Helpers, find that their results get worse, and they sink into despair. But just as hope seems lost, a fourth group – we’ll call them the hyper-Helpers – appears. These friendly folk explain to the Gotrocks that their unsatisfactory results are occurring because the existing Helpers – brokers, managers, consultants – are not sufficiently motivated and are simply going through the motions. “What,” the new Helpers ask, “can you expect from such a bunch of zombies?” The new arrivals offer a breathtakingly simple solution: Pay more money. Brimming with self-confidence, the hyper-Helpers assert that huge contingent payments – in addition to stiff fixed fees – are what each family member must fork over in order to really outmaneuver his relatives. The more observant members of the family see that some of the hyper-Helpers are really just manager-Helpers wearing new uniforms, bearing sewn-on sexy names like HEDGE FUND or PRIVATE EQUITY. The new Helpers, however, assure the Gotrocks that this change of clothing is all-important, bestowing on its wearers magical powers similar to those acquired by mild-mannered Clark Kent when he changed into his Superman costume. Calmed by this explanation, the family decides to pay up. And that’s where we are today: A record portion of the earnings that would go in their entirety to owners – if they all just stayed in their rocking chairs – is now going to a swelling army of Helpers. Particularly expensive is the recent pandemic of profit arrangements under which Helpers receive large portions of the winnings when they are smart or lucky, and leave family members with all of the losses – and large fixed fees to boot – when the Helpers are dumb or unlucky (or occasionally crooked). A sufficient number of arrangements like this – heads, the Helper takes much of the winnings; tails, the Gotrocks lose and pay dearly for the privilege of doing so – may make it more accurate to call the family the Hadrocks. Today, in fact, the family’s frictional costs of all sorts may well amount to 20% of the earnings of American business. In other words, the burden of paying Helpers may cause American equity investors, overall, to earn only 80% or so of what they would earn if they just sat still and listened to no one. Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac’s talents didn’t extend to investing: He lost a bundle in the South Sea Bubble, explaining later, “I can calculate the movement of the stars, but not the madness of men.” If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases. Download Malkiel/Saha paper © Copyright 2007 by Finfacts.com |
