Hedge Funds
For the period 1998-2012, Bernstein analyzed Hedge Fund Research’s Global Returns series using a three-factor analysis — meaning analyzing the exposure to the risks of the stock market, small stocks and value stocks. He found that while hedge funds showed significant outperformance early on, that outperformance shrank and then turned negative as investors chased those returns. From 1998 through 2002, hedge funds produced an incredible alpha (or outperformance) of 9 percent. However, from 2003 through 2007, their alphas went to -0.7 percent. And from 2008 through 2012 the alpha sank even further to -4.5 percent.
Why did that happen? David Hsieh, professor of finance at Duke’s Fuqua School of Business, provided a simple explanation — alpha is a finite resource. In 2006, Hsieh estimated that there was about $30 billion in alpha available to the entire hedge fund industry. The implication is that as more money enters the industry, there’s less and less alpha to go around per hedge fund. This wasn’t good news for hedge fund investors, because dollars had been flowing in at a rapid pace.
Assuming his estimate is correct, we can now determine what that means for hedge fund investors using simple math. Hsieh estimated that at the time the industry had about $1 trillion under management. Thus, $30 billion of alpha spread over $1 trillion of assets is 3 percent alpha for the industry.
A couple of points that help offset this story of a greater supply of alpha. First is that at least in the US the absolute number of stocks traded on US exchanges has dropped dramatically over the past decade or so. From a USA Today article we see that from the year 2000 to 2012 the number of US listed companies has gone from 6,639 all the way down to 3,687. This drop has any number of implications one of which being a smaller pool in which managers can fish.
The second point is that over this time period the number of hedge funds, and the amount of money they manage, has increased dramatically over roughly this same time period. This means that managers are now stepping on each others toes to try and generate alpha. So even if the raw amount of potential alpha increased over this time period it is being spread over a much larger pool of managers. As Josh Brown at the Reformed Broker writes:
And now, all of this sameness and the mass-pursuit of market inefficiencies has led to an industry filled with intelligent players stifling each others abilities. Of course it did. If the world’s top fifty surfers all had to ride the same wave at the same time, how well could any of them do it? Jostling and elbowing each other for space and clear blue, whatever edge they originally paddled out with would be negated by simple physics.
The net result of all of this is that generating alpha is still a tricky business. Some ETF providers are trying to fudge the distinction between low cost, plain vanilla indexed ETFs which are now available at nearly zero cost and the many flavors of quasi-active index funds which have higher fees and track more narrow indices. Now matter how you slice the data the benefits of index-style investing are still visible in the data and increase with the amount of time you hold those funds.
Top 10 Highest-Paid Hedge Fund Managers of 2012
1. David Tepper (Appaloosa Management): $2.2 billion
2. Ray Dalio (Bridgewater Associates): $1.7 b
3. Steven Cohen (SAC Capital): $1.4 b
4. Jim Simons (Renaissance Technologies): $1.1 b
5. Ken Griffin (Citadel): $900 million
6. Eddie Lampert (ESL Investments): $750 m
7. Stephen Mandel (Lone Pine Capital): $580 m
8. Leon Cooperman (Omega Advisors): $560 m
9. David Shaw (D.E. Shaw): $530 m
10. Dan Loeb (Third Point): $380 m
Merecen la pena los hedge funds?
Soros, considered by some to be one of the greatest investors in history, announced in 2011 that he was returning most of his investors’ money and converting his fund into a family office. Simons, a former mathematician and code cracker for the National Security Agency, retired from managing his funds in 2010. After several spectacular years, Paulson saw performance at his largest funds plummet, while Falcone reached a tentative settlement in May with the U.S. Securities and Exchange Commission over claims that he’d borrowed money from his fund to pay his taxes, barring him from the industry for two years. Griffin recently scaled back his ambition of turning his firm into the next Goldman Sachs (GS) after his funds struggled to recover from huge losses in 2008.
After a decade as rock stars, hedge fund managers seem to be fading just as quickly as musicians do. Each day brings disappointing headlines about the returns generated by formerly highflying funds, from Paulson, whose Advantage Plus fund is up 3.4 percent this year, after losing 19 percent in 2012 and 51 percent in 2011, to Bridgewater Associates, the largest in the world.
Despite all the speculation and the loss of billions in investor capital, Cohen’s flagship hedge fund managed to be the most profitable in the world in 2012, making $789.5 million in the first 10 months of the year, according to Bloomberg Markets. His competitors haven’t fared as well.
Hedge funds are built on the idea that a smarter guy (and they are almost all guys; only 16.8 percent of managers are women) with a better computer can make miracles possible by uncovering inefficiencies in the market or predicting the future. In pure dollar terms, there are more resources, advanced degrees, and computing firepower devoted to chasing this elusive goal than almost any other endeavor, and that may include fighting wars. Yet traders face the immutable fact that every second, each megabyte of information, blog post, one-line rumor, revenue estimate, or new product order from China has already been taken into account by the efficient market and reflected in a security’s price. This means that trying to gain what traders call an “edge,” at least legitimately, is almost impossible. As the financial incentives on Wall Street have become enormous, so have the competition and pressure to gain an advantage at any cost.
For a while, the funds were expected to produce steady, modest returns, in contrast to the wider swings of the market. In a 2011 paper that he updated this year, Roger Ibbotson, a finance professor at the Yale School of Management who runs a hedge fund called Zebra Capital Management, analyzed the performance of 8,400 hedge funds from 1995 to 2012; he concluded that on average they generated 2.5 percent of precious alpha. “They have done a good job, historically,” Ibbotson says. “Now, I think it’s overcapacity. I doubt that the alphas are completely gone, but alphas are going to be harder to get in the future than they have been in the past.”
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