Marginal Revolution: Hedge Funds

Tyler Cowen writes:

Marginal Revolution: Hedge funds: I've found at least one good piece on them, by Rene Stulz, in the Spring 2007 Journal of Economic Perspectives.  I learned or reaffirmed the following:

1. Hedge funds have existed since at least 1949.
2. Hedge funds exist because mutual funds do not deliver "complex investment strategies."  In part this is because mutual funds are regulated.
3. The largest mutual fund is about six times larger than the largest hedge fund.  Marketing constraints also encourage very large funds to adopt simpler and easier-to-explain strategies.
4. Investment advisors with fewer than 15 clients do not have to register with the SEC.
5. Regulations restrict the compensation of mutual fund advisors in various ways, typically requiring symmetric treatment of gains and losses (if a dollar of profit leads to a bonus, a dollar of loss must lead to a penalty).  That is why mutual fund managers are compensated in proportion to the size of their funds, not their performance.  This is not obviously efficient, and of course hedge funds pay for performance.
6. Hedge funds don't have to disclose information to investors, other than by contractual agreement.
7. Diversification and redemption requirements make it harder for mutual funds to exploit some profit opportunities, or to hedge in particular manners.
8. The number of mutual funds that try to replicate hedge fund strategies is growing rapidly.
9. Available data on hedge fund returns are nearly worthless.

Overall I was struck by how much hedge fund activity is an artifact of regulations, and not necessarily beneficial regulations.  Deregulating some aspects of mutual funds may be an alternative to regulation of hedge funds...

Comments

[Matt]

Hedge funds, when working well, remove system cycles in the economy. I speculate that most biases result from bubbles, generlly originating on the right side of our X spectrum, where correlations are high among the P(z) over there.

Hedge funds keep the bubble from oscillating. So, whenever we all want to rush into the federal legislature and start price fixing the large government institutions, often these hedgers get richer by mitigating the powerfactor loseses we incure.

[pi]

A friend who invests some of an insurance company's money in hedge funds mentioned two addional reasons why hedge funds are attractive:

(1) They allow allow "conservative" investors to do things indirectly that they would be embarrassed to do on their own (or maybe even prohibited from doing). I.e., when I asked my friend why they paid somebody a lot of money to implement a relatively simple sounding strategy rather than just doing it themselves, he said that carrying out the strategy required investing in securities that their stated policies prohibit. This fits in fairly well with TC's characterization of the driving forces if one thinks the policies were silly or imposed by regulators. But, I think in this instance, the policies were adopted by a big insurance company in an effort to keep their ratings high. So, it's possibly a bit of an agency problem.

(2) The second reason: Great tickets to sporting events. By far the best tickets to baseball and basketball games I've ever had have been when my friend is in town to "interview" a prospective hedge fund.

[Bruce Webb]

Two words come to mind when I think of deregulating mutual funds so our hedge fund bird friends can fly free: LCTM and Enron.

In a Democracy the majority is likely to favor Equity over Efficiency, it accepts that regulation and taxation may to some degree limit Efficiency but accept that for the overall improvement to the Social Welfare. Which puts the Tyler Cowans in a bind, in order to get the majority to go along with their policies they are required to make a case that they will be providing equivalent utility, equal Social Welfare.

Because 'Greed is Good' doesn't work. 'What is in it for me?" is a legitimate question in any market society. They have to make the case to the majority or why should we go along.

They aren't doing well. Not because people are economic cretins, no because they are looking around and not seeing the results that the Voodoo doctors promised. The days are past when Free Market people could simply assert their positions as transparent truths, give me some deliverables.

Particularly interesting is Bryan Caplan. He suggests that the fact that workers indirectly voted to give themselves a raise through Minimum Wage shows they are so ignorant that we should reconsider One Man, One Vote. The fact that he has nothing but theory to suggest that the net effects on total worker income are not so positive to swamp out any job losses at the margins doesn't phase him.
http://econlog.econlib.org/archives/2007/06/see_oneman_onev.html

It is kind of a peculiar outlook that suggests that a democracy should disenfranchise citizens simply to free markets.

[Bruce Webb]

Or LTCM.

[Bernard Yomtov]

"Regulations restrict the compensation of mutual fund advisors in various ways, typically requiring symmetric treatment of gains and losses (if a dollar of profit leads to a bonus, a dollar of loss must lead to a penalty). That is why mutual fund managers are compensated in proportion to the size of their funds, not their performance. This is not obviously efficient, and of course hedge funds pay for performance."

Excuse me.

Why doesn't symmetric treatment of gains and losses constitute pay for performance?

How is the one-sided compensation system enjoyed by hedge fund managers "obviously efficient?"

Doesn't this one-sided system encourage excessive risk-taking in some circumstances?

[anne]

Thank you, Bernard, but there is so much more, for this is an amazingly ignorant summary analysis.

For instance, hedge fund managers are paid a typical 2% of assets before a percentage of profits. Size alone is ample reward for a hedge fund manager, relatively more ample than for mutual fund managers who are often paid additionally for performance.

The 2% hedge fund management fee can be compared with the most efficient of all funds, index funds, in which the entire cost to a somewhat smallish Vanguard investor is .18%.

[anne]

There is so much more to correct; including having an increasing understanding of hedge funds returns and finding the returns as a class trailing index funds in investor returns by, well, the absurd costs.

Well, then, what about the hedging? Are hedge fund returns after adjusting for risk better than index fund returns? No; as John Bogle long ago pointed out and Charles Munger echoed a percentage point of return is much preferred to a point given up for supposed risk hedging when long term diversified investment is a proper hedge as such.

Of course, there are always wonderful investment managers from a minimally paid David Swensen at Yale to the billion dollar plus plus plus a year hedge fund manager to the managers of the Vanguard minimal cost health care fund who have been averaging returns of about 20% for more than 20 years.

But, the real key to understanding the attractiveness of hedge funds resides in the astonishing tax advantages of the fund which are no wise addressed in the analysis.

[Maynard Handley]

Hmm.
"Available data on hedge fund returns are nearly worthless."
but even so we can, apparently, conclude that they are substantially better than mutual funds?

Numbers please. After those running them have their cut, and my tax implications are taken into account, how are we doing compared to Vanguard? And what does that pattern look like over the long term, good times and bad?

I've no doubt hedge funds are a great deal for those who run them, and no doubt that those who run mutual funds would love to create a similar situation wrt to their compensation. But as an investor rather than a manager, why is this of any interest to me?

Or, to put it bluntly, who are Rene Stultz' clients? Me or mutual fund managers looking to get rich?

[howard]

some of the substantive issues have already been doubt with - the idea, for example, that hedge fund managers are paid for performance, unless performance means "attracting more assets upon which to exact the 2% fee anne noted" - but i'm interested in the historic issue, and i guess i'll have to track down the article.

from my reading of wall street history, what we today call "hedge" funds started in the '60s, when they were originally called "hedged" funds, a philosophy that it's not clear many of the funds still follow. on the other hand, i once saw an interview with warren buffett in which he noted that graham-newman, his mentor's fund, would today be called a "hedge" fund, and graham-newman was certainly around by the late '40s at least (although at the end of the day, if ben graham is to be trusted, graham-newman's best investment was GEICO, but i digress). anyone else know any more about hedge fund history?

[anne]

http://www.irs.princeton.edu/krueger/12_09_2004.htm

December 9, 2004

Those lofty reported returns show that hedge funds are more skilled at managing data than managing money, a study says.
By ALAN B. KRUEGER - New York Times

HEDGE funds have grown at supersonic speed. In 1990, about $50 billion was invested in hedge funds; today, the amount is estimated at $1 trillion.

Does superior performance explain the rapid growth? No, says Burton G. Malkiel, a professor of economics at Princeton University, and Atanu Saha, a managing principal at the Analysis Group, a consulting firm. The researchers recently completed a study that challenges the often-made claim that hedge funds, in general, produce lofty returns.

Hedge funds are a diverse set of investment funds that typically cater to wealthy clients and institutions. The funds pursue various strategies, like holding both long and short positions, and often employ substantial leverage. Their fees are usually much higher than those charged by mutual funds or other financial assets.

Data on the performance of hedge funds comes from indexes like the CSFB/Tremont Index or the Van Hedge Fund Index. Those indexes are generated by companies that advise investors and operate funds.

''Hedge funds in aggregate,'' Van Hedge Fund Advisors boasts on its Web site, ''in most multiyear periods, have provided both superior returns and lower statistical risk than the S.& P. 500 or mutual funds.''

The catch, according to Professor Malkiel, is that the information on performance is voluntarily provided to the organizations who track the funds. Because a good record helps attract investors, funds have a tendency to start reporting results only after they have achieved some success. Funds that are losers right out of the gate may never be represented in the database.

Furthermore, when funds start reporting, they have the option of ''backfilling'' their data, or providing information on returns for previous months. If a fund was successful in preceding months, it has an incentive to backfill its data to increase its attractiveness to investors.

This process creates a ''backfill bias,'' because better results are overrepresented in the database. It is as if the Boston Red Sox waited until 2004 to report their World Series success, while the Yankees started in 1923; both franchises would look like smashing successes.

By analyzing statistics from TASS Research, which is owned by Tremont Capital and has perhaps the most comprehensive data on returns, Mr. Malkiel and Mr. Saha have shown that the backfill bias is substantial. The returns that were backfilled for a given year were 5.8 percentage points higher than the returns of other funds whose results were contemporaneously reported for that year....

[anne]

http://www.nytimes.com/2007/06/08/business/08insider.html?ex=1338955200&en=a99475c6c5a79cfb&ei=5090&partner=rssuserland&emc=rss

June 8, 2007

As Money Pours in, Hedge Funds Come to Look More Like the Markets
By JENNY ANDERSON

"We are somewhere between the third and fifth inning in the growth of assets invested in alternative strategies," said Todd Builione, a managing partner at Highbridge Capital Management, a $15.7 billion hedge fund that is majority owned by JPMorgan Chase.

Indeed. According to Douglas C. Wurth, global head of alternative investments at JPMorgan Private Bank, $1 billion a month is flowing into hedge funds on JPMorgan's platform, where wealth managers are now recommending that very rich individuals ($25 million or more) and institutions put 35 percent of their portfolios in alternatives, and 20 percent of that into hedge funds.

Mr. Wurth and Mr. Builione were both speaking on a panel with other senior executives from the private bank at a briefing in New York. It was clear that alternatives continue to be the rage for a number of reasons, including the low correlations that hedge funds have historically had with major equity and bond markets. In other words, when those markets tank, hedge funds, in general, do not.

Then there's Ray Dalio.

Mr. Dalio, the founder of Bridgewater Associates, a hedge fund with about $30 billion under assets, has some different thoughts on his industry, including some tough questions on why hedge fund returns look so much like stock market returns when they are not supposed to be correlated.

In a private research letter sent out this month, he and a colleague examined the correlation of hedge fund returns to the returns of certain market indexes.

In general, hedge funds returns should not replicate stock market returns. If they did, investors would be smarter to buy index funds and not pay the steep fees of hedge funds....

[anne]

As hedge funds become the market, then returns to the funds in general become market returns minus the cost. Similarly, this is precisely what Warren Buffet repeatedly tells investors in Berkshire Hathaway, but Warren Buffett has a secret, which he tells but few hear. The secret is Berkshire Hathaway has an astonishingly low investment management cost. So, a clever Warren Buffett only has to be a little clever, a little patient, to show fine returns.

[anne]

http://www.nytimes.com/2007/05/23/business/23leonhardt.html?ex=1337572800&en=38f5a54b7a7e6eaf&ei=5090&partner=rssuserland&emc=rss

May 23, 2007

Worth a Lot, but Are Hedge Funds Worth It?
By DAVID LEONHARDT

The reason hedge funds are a license to print money is their fee structure. A typical fund charges a 2 percent management fee, which means that it keeps 2 cents of every dollar that it manages, regardless of performance. Mutual funds, on average, charge about 1 percent.

On top of the management fee, hedge funds also take a big cut — usually at least 20 percent — of any profits that exceed a predetermined benchmark.

So in a good year, a fund's managers bring in stunning amounts of money, and in a bad year, they still do very well. Some quick math shows why: 2 percent of a $5 billion portfolio, which was roughly the cutoff for making Alpha's list of the 100 largest funds, equals $100 million. A fund's managers get to take that fee every single year.

Last year was actually a pretty tough year for the industry. Because hedge funds tend to make a lot of countercyclical bets — thus the name — they can often turn a profit even when the stock market falls. When it's rising broadly, though, many struggle to keep up. Last year, the Standard & Poor's 500-stock index jumped 14 percent, while the average hedge fund returned less than 13 percent, after investment fees, according to Hedge Fund Research in Chicago....

The 100 largest firms in the world managed $1 trillion at the end of last year, or 69 percent of all the assets in hedge funds, according to Alpha. At the end of 2003, the top 100 had less than $500 billion, or only 54 percent of total hedge fund investments.

"The best performance is coming from the largest funds," said Christy Wood, who oversees equities investments for the California Public Employees' Retirement System, which, like a lot of pension funds, is moving more money into hedge funds.

But there is an irony to this influx of money. It all but guarantees that hedge fund pay over the next few years won't be as closely tied to performance as it has been. The hundreds of millions of dollars that have flowed into hedge funds have made it all the harder for fund managers to find truly undervalued investments. The world is awash in capital.

All that capital, of course, also translates into ever-greater management fees, regardless of a fund's performance. The flagship hedge fund at Goldman Sachs lost 6 percent last year, but it still brought in a nice stream of fees. Bridgewater Associates, which is based in Greenwich, has earned a net return of less than 4 percent in each of the last two years. Yet its founder, Raymond T. Dalio, made $350 million in 2006.

"When we have a bad year, we're essentially flat," Parag Shah, a Bridgewater executive, told me. "And when we have a good year, we have a great year."

Goldman and Bridgewater may well bounce back, but the combination of extraordinary pay and ordinary performance is going to occur more and more in the coming years.

Outside of the highfliers on the Alpha list, it's already the norm. Since 2000, the average hedge fund hasn't done any better, after fees, than the market as a whole, according to research by David A. Hsieh, a finance professor at Duke. Still, even mediocre managers, after a lucky year or two, are able to attract gobs of capital and charge "2 and 20." ...

[baileyman]

Thanks to Howard, an historical correction.

Ben graham is the place ot go to get some understanding of when investment partnerships got started. He was running one in the 19 teens. His autobiography speaks much of his own history. The early ones had wild arrangements, 25% no fee, 20% and a fee, sometimes a partnership of two with a capital partner and a junior who did all the work split 50/50. It does not talk about the true beginnings, though.

The best I can find is to note that ships' captains have been compensated similarly. So you have a bunch of investors in a cargo, and the captain takes part of the proceeds. The old houses in Salem, MA speak about how richly these guys were compensated. This was 200 years ago. But I'm guessing it goes back much further. Phoenicia?

"Hedge" as a term was invested by AW Jones. But that's like putting a brand on a tree.

I've corresponded with academics about the origins. I've yet to find one who knew anything prior to 1949. Shoddy.

[anne]

Again, as Maynard wonders, there are terrific hedge funds, as there is a terrific Vanguard health care fund or energy fund which have returned 19.3% and 15.2% a year for 22 years. The Vanguard S&P index has returned 12.4% a year for a little more than 30 years. Low turnover, low taxes. Not all that much to be jealous about, if anything at all.

[uberdave]

Everyone, take a look at CSFB / Tremont hedge fund returns (yes there is some survivor bias among other concerns). Learn about or refresh your CAPM theory. Beta, the market return, is great for the long term. The S&P 500 has a return of around 10% and risk of around 16-17% long term, give or take. As many here have noted, Vanguard will charge you 0.18% for that profile, and everyone should put a chunk of savings there.
The problem is, for many investors that is not good enough. Other simple asset classes (corporate bonds, emerging markets) can be added cheaply to the mix, but aggressive funds and rich folks still want more.
To go beyond that, you have to find alpha: exotic assets, complex models, ostensibly market-neutral strategies like convert arb, merger arb, etc.
COMPARISON WITH S&P IS IRRELEVANT AND IGNORANT! You have to look at risk and correlation as well; if these are low then such an investment is simply superior to long-only stocks, and it is worth paying high fees for (assuming it can be sustained and is not the product of luck).
We believe in free markets, I'm sure; this is an econ blog. So there is only one answer to 'Why is the price so steep at 2 and 20'? That's like asking why is the price of filet mignon more than that of a Big Mac! And the best funds charge 3 and 50, while many charge 1&20. Even so, many hundreds of funds still go out of business every year of course, it's a ruthlessly competitive business.

[nemo]

Tyler Cowen had to go digging in the Spring 2007 Journal of Economic Perspectives to learn this obvious stuff about hedge funds? Allow me to snort.

Except for item 4 and the first sentence of item 3, there is not one single piece of information in the 9 items he cites here that did not appear in a chatty series of articles in a Spring 2007 issue of the glossy New York Magazine:

http://nymag.com/news/features/hedgefunds/

The NY Magazine articles also contains a good short history of the term "hedge fund", and why the term is now pretty meaningless for the biggest, most famous hedge funds. They're not into risk avoidance, and they don't hedge anymore.

[nemo]

I just read the first 5 pages of the Rene Stulz paper, and searched the rest for references to regulation. It's clear that Tyler Cowen is more obsessed with regulation that Rene Stulz , and over-emphasizes the role of regulation in Stulz's paper.

Stulz believes that over time hedge funds will increasingly converge towards conventional mutual funds in their strategies, but the threat of regulation is only only one of his three reasons. Stulz also cites what he considers two powerful market forces that will also make hedge funds more similar to mutual funds.

Stulz believes that growth of the hedge fund industry will cause institutional investors to play a larger hand, which will increasingly constrain the discretion exercised by the hedge fund managers in order to satisfy the fiduciary responsibility of institutional investors.

Stulz also believes that as hedge fund assets under management keep growing, some strategies will become unprofitable, exactly the problem faced by large actively-managed mutual funds.

Cowen's anti-regulatory prejudices are distorting his reading ability.

[anne]

Agreed, Nemo.

Also, what always impresses me immediately that someone is so wrong as not to be worth the reading is when the someone needs to CAPITALIZE to make sure the rest of us will accede to this or that idiocy.

"That's like asking why is the price of filet mignon more than that of a Big Mac!"

I would have neither, and imagine all of my thin-ness and health and you know what they say about, well, you know....

[anne]

"That's like asking why is the price of filet mignon more than that of a Big Mac!"

A matter of sad indifference if you're a cow. Say what?

[Bernard Yomtov]

"And the best funds charge 3 and 50, while many charge 1&20."

For "best" perhaps we should read "luckiest."

[venky]

I don't see why we should deregulate mutual funds. Optional regulation gives a wider choice set for everyone than no regulation or forced regulation.

[the idler]

Outside of James Simons, they are all charlatans.

[ladeluge]

Thanks Anne,

When you wrote:

"But, the real key to understanding the attractiveness of hedge funds resides in the astonishing tax advantages of the fund which are no wise addressed in the analysis."

It's been my impression for some time that the amount of tax that is 'avoided' would surprise most people, but I've never seen any studies. Your post suggests that I should take another look for sources.