Note: This is my 1,000th post at Above the Market, which began publication nearly five years ago, in August of 2011. I remain as astonished as ever at the attention it has received. I am grateful to each and every reader. Thank you.
In 1821, a man named William Hart dug the first natural gas well in the United States on the banks of Canadaway Creek in my home town of Fredonia, New York. The well was 27 feet deep, was excavated by hand using shovels, and its gas pipeline consisted of hollowed out logs sealed with tar and rags. Natural gas was soon transported to businesses and street lights in town. These lights frequently attracted travelers, often causing them to make a significant detour to see this new “wonder.” Expanding on Hart’s work, the Fredonia Gas Light Company was formed in 1858, becoming the first American natural gas company.
Gas lighting is thus an inexorable part of my personal history. But I’m even more interested in gaslighting.
In the 1938 play Gaslight, a murderous husband is intent on inducing instability in his wife in order to accommodate his venality. When she notices that he has dimmed the gaslights in their house, he tells her she is imagining things—that they are as bright as ever – as a way to get her to question her senses and her sanity. The British play became a classic 1944 American film from George Cukor, starring Ingrid Bergman as the heroine and Charles Boyer as her abusive spouse, out to convince her that reality is not what she perceives. In this sort of story, our most dangerous enemies are always those closest to us, masquerading as lovers and friends. Gaslight reminds us how uniquely terrifying it can be to mistrust the evidence of our senses and of what we know to be true.
Taking off from the film, “gaslighting“ in contemporary usage means a form of intimidation or psychological abuse whereby false information is systematically presented to the victim, causing him to doubt his own memory, perception or even his sanity. As in the movie, gaslighting is a hallmark of domestic abuse, but one can see its use and impact almost everywhere. I wrote much of this while in Washington, D.C., perhaps the world’s gaslighting capital.
In the investment management world, the overarching priority for the vast majority of money managers is to gather assets and revenues and only peripherally to provide quality performance for investors. Gaslighting is routinely used to try to obscure those priorities and to convince investors that, despite the reality of what they see, investing in product X or with firm y is a smashing good idea.
To be sure, money managers do indeed want very much for their strategies, funds and investment approaches to succeed. Good investment performance makes growing assets and revenues much easier, after all, and improves client “stickiness” enormously. But that isn’t the top priority – not by a long shot. Never mistake what investment management marketing says (or implies) with truth.
Hedge funds are the obvious low-hanging fruit when looking for gaslighting in finance. As Victor Fleischer famously put it, “hedge funds are a compensation scheme masquerading as an asset class.” The initial hedge fund pitch (I was in an early pitch meeting for the ill-fated Long-Term Capital Management in 1994) generally focused on outsized returns that promised more than enough juice to justify the exceedingly large concomitant fees.
But it was all gaslighting. Performance didn’t remotely live up to the hype. LTCM spectacularly blew up in 1998 – and I watched the bid lists flow in via fax to the Merrill Lynch bond trading floor.
At the Berkshire Hathaway 2007 shareholder meeting, Warren Buffett, the Berkshire Chairman, offered to bet any taker $1 million that over ten years and after fees, the performance of an S&P 500 index fund would beat ten hedge funds that any opponent might choose. Protégé Partners, which oversees funds-of-hedge-funds, rose to the challenge. Protégé hoped to demonstrate that “funds of funds with the ability to sort the wheat from the chaff [would] earn returns that amply compensate for the extra layer of fees their clients pay.”
The wager began on January 1, 2008 and is set to conclude on December 31, 2017. With two years to go, Buffett has a comfortable lead. Fortune reports that at the end of 2015, Buffett’s bet had returned a cumulative 65.67 percent while the average return of the Protégé picks stood at just 21.87 percent.
That background goes a long way towards explaining Buffett’s comments last weekend at this year’s Berkshire Hathaway annual meeting. “It might sound like a terrible result for hedge funds but not a terrible result for hedge fund managers,” Buffett said. Although it’s not nearly so prevalent now, largely on account of the poor performance I’m highlighting, hedge funds generally try to charge a management fee of 2 percent of assets plus 20 percent of any profits. “There’s been far, far, far more money made by people in Wall Street through salesmanship abilities than through investment abilities,” Buffett noted. Buffett added that if he had a similar arrangement with his two investment managers, who each manage $9 billion at Berkshire, “they’d be getting $180 million each merely for breathing.” That compensation scheme is “unbelievable to me,” Buffett said, adding that that’s one reason he made the bet.
Clearly, nobody should be using hedge funds for expected outperformance alone. Hedge funds delivered their worst performance in years in 2015 (which really says something) as onetime industry kings David Einhorn and Bill Ackman posted some of their biggest losses ever, with each down 20 percent. Hedge funds entered 2016 after a seventh-straight year of trailing U.S. stocks (as measured by the S&P 500) by significant margins. Indeed, for the 10-year period ending December 31, 2015, the HFRX Global Hedge Fund Index managed to return just 0.7 percent per year, underperforming every single major equity and bond asset class (and survivorship/delisting bias makes the actual results even worse than they appear). Investments designed to replicate hedge fund strategies in a mutual fund wrapper aren’t working very well either.
When analyzed on an asset-weighted basis, hedge fund returns are even worse. As Simon Lack documented in his book, The Hedge Fund Mirage, if all the money that has ever been invested in hedge funds had been invested in U.S. Treasury bills instead, the overall results would have been twice as good. That is remarkable evidence that the hedge fund industry is simply too large to provide healthy returns overall (as even Steve Cohen and Cliff Asness concede).
That failure – and it is a monumental failure – is largely on account of outsized fees (as noted above). The notorious “two and 20” makes realizing the outsized gains hedge fund investors typically expect essentially impossible to obtain in the aggregate, despite a handful of prominent success stories. Indeed, the hedge fund industry retained in fees 84 percent of the total dollar profits generated from invested capital, leaving just 16 percent for investors. Including fees charged by fund-of-funds (to whom nearly half the investors delegate the hedge fund selection and portfolio construction), the share enjoyed by investors falls to just 2 percent.
With so many managers currently chasing too few good ideas, returns necessarily suffer. Every year the Sohn Investment Conference (going on now in New York) is a really big deal. It’s perhaps the premier hedge fund conference. Lots of big-name hedge fund managers share what purport to be their best ideas. However, Bloomberg reports that only two of last year’s speakers had winning ideas (as opposed to lots of losing ones), and even those apparent winners had poor calls that overwhelmed their winners in the aggregate.
Things have gotten so bad that just this week Steve Cohen bemoaned the lack of talent available to hedge funds (although Josh Brown is surely right that the more likely problem is too much talent along with and too much money chasing too few good trades rather than too little). Cliff Asness and John Liew put it bluntly and accurately: “We believe the vast majority would be better off acting like the market was perfectly efficient than acting like it was easily beatable. Active management is hard.” The very best one can say about hedge fund performance is that hedge funds have suffered a very tough run since the financial crisis.
Few investors of any sort should find that good enough. No retail investor should.
Since marketing hedge funds on outsized performance has failed under the weight of their (non) performance as more and more money moved into the hedge fund space, the focus of the substantive marketing pitch has shifted to non-correlation, risk control and outperformance in difficult markets. This pitch tries to say that the lousy performance we have been seeing isn’t the performance that matters.
To be fair, some criticism of hedge funds does go too far (Asness made this point on Bloomberg TV this week – video available here). Since equities – and especially domestic equities – have performed so exceedingly well since the financial crisis, since hedge fund beta is by definition less than 1.0 (because they hedge), and since hedge funds tend to look more globally for investments, at least some of the massive underperformance we have seen since the financial crisis is to be expected. Similarly, since hedge fund beta well exceeds 0.0 – they aren’t generally fully hedged, even if perhaps they should be – expecting them to avoid losses entirely in difficult markets isn’t reasonable either (even if drawdowns in excess of 20 percent in 2008 were much worse than hedge fund managers generally led their clients to believe were possible). Finally, mean reversion is a real thing.
However, the full body of available evidence compellingly shows that hedge funds haven’t lived up to the more nuanced recent hype either. Indeed, hedge fund promise far outpaces performance – by any measure. “Despite promises of better and less correlated returns, hedge funds failed to deliver significant benefits to any of the pension funds we reviewed,” one prominent study found. “Our analysis suggests that hedge funds as an investment product fall short of both of their major selling points: outsized returns that offset the exorbitant fees and uncorrelated returns that smooth out market volatility and offer investors protection during economic downturns.”
According to an important 2010 Ibbotson study, gross of fees, the annual hedge fund return to investors over the period from 1995 to 2009 was 11.42 percent, but still provided significant alpha and risk-adjusted returns. However, management and performance fees reduced this figure by 3.79 percentage points and thus to well less than the S&P offered. Therefore, even if hedge funds are generating decent alpha, they are keeping nearly all of it for themselves. Moreover, and more importantly, there has been a persistent decline in hedge fund alpha and risk-adjusted returns since 2000 along with increasing correlations. These flaws don’t even speak to the general lack of transparency from hedge funds and the lack of liquidity provided by hedge fund investments.
It is axiomatic in the investment world that as an asset class, strategy or approach becomes more popular, it suffers from both falling expected returns and rising correlations. Size is the enemy of performance. Hedge funds did very well, sometimes spectacularly well, in their early days during the 1990s when the industry was small. But as the industry has grown, returns have fallen dramatically. Very few real live investors achieved even the average results claimed because they are distorted by the initial strong performances hedge funds enjoyed when the industry was far smaller.
In other words, good trades get crowded and their advantages tend to disappear. This crowding happens because success begets copycats as investors chase returns. Mean reversion only tends to make matters worse, as we have seen of late. In effect, it results in “investing while looking in the rear-view mirror.” Now that trillions of dollars are invested in hedge funds, there is no reason to think that the halcyon days can return.
The key (and related) questions for potential hedge fund investors, therefore, are whether (a) the performance problems suffered by hedge funds since the financial crisis are more a function of the market environment or more a function of overcrowding; and (b) one has the ability to ascertain which hedge funds will succeed while also allowing you access (because, after all, hedge funds are not an asset class).
Warren Buffett’s comments over the weekend suggest overcrowding is the driver of poor performance. But more importantly, David Swensen, long-time head of the Yale Endowment, insists (Asness makes the same point) that few will have access to first-rate hedge funds even if and when it is possible to predict in advance which of them are truly first rate. In his book Unconventional Success, Swensen provides these cautionary words: “In the hedge fund world, superior active management constitutes a rare commodity. Assuming that active managers of hedge funds achieve success levels similar to active managers of traditional marketable securities, investors in hedge funds face dramatically higher levels of prospective failure due to the materially higher levels of fees.” As for funds of hedge funds, Swensen called them “a cancer on the institutional-investor world” and said they “facilitate the flow of ignorant capital.”
As Chris Brightman of Research Affiliates likes to say, “The hedge funds that produce [great] results will never manage your money.” And as Nobel laureate Eugene Fama noted: “If you want to invest in something where they steal your money and don’t tell you what they’re doing, be my guest.” Rex Sinquefield, co-founder of Dimensional Fund Advisors, went even further, calling hedge funds “mutual funds for rich idiots.” These testimonies and the data that supports them should seal the deal: there is very little reason or necessity for most investors to rely on hedge funds.
As a consequence, hedge fund assets may finally be falling , some institutions are getting out and protests against the industry are intensifying. But there is another – implicit – reason investors use hedge funds. It is crucial to the hedge fund mystique and supported by major charitable giving, hedge fund manager prominence in the society pages and even the Showtime television hit, Billions.
Meir Statman of Santa Clara University provides this added explanation: “Investments are like jobs, and their benefits extend beyond money. Investments express parts of our identity, whether that of a trader, a gold accumulator, or a fan of hedge funds.” He then explains that people frequently invest in hedge funds for the same reason they buy a Rolex – they are expressions of status available only to the wealthy. This status is fundamental to hedge fund allure despite dreadful performance, and hedge fund marketing takes full advantage.
Hedge funds are thus the perfect investment vehicle in the age of Trump – selling “luxury” to people with no concept of value. Effective “gaslit” marketing consistently gets the job done for hedge fund managers. Reality simply doesn’t matter.