Just Take The Average

A standard result in finance is that investment advisors and actively managed mutual funds tend to lose (risk-adjusted) money relative to simple "take the average" investment strategies.  The July 2 New Yorker tells that hedge funds are no exception:

Unlike banks and brokerage firms, hedge funds are largely unregulated … Typically, hedge-fund managers charge their clients a management fee equal to two per cent of the amount they invest, plus twenty per cent of any profits that the fund generates. … 

A [2003] study …compared the fee-adjusted returns of seventy-seven hedge funds between 1990 and 2000 with the returns generated by a market benchmark that had a similar risk profile.  Seventy-two of the funds – more than ninety per cent – failed to outperform their benchmarks. … A larger study … examined more than nineteen hundred funds. … Only eighteen per cent of the funds outperformed their benchmarks, …..

[Worse,] many published estimates of hedge-fund returns are misleading. … [since] funds tend to exaggerate how well they performed in the past, and that those which perform badly often close and disappear from databases, leaving a biased sample. …. between 1996 and 2003 hedge funds made an average return of 9.32 per cent, significantly less than the 13.74-per-cent average return of funds included in the published databases.

The article also discusses how simple computer programs can "generate returns with the same, and often better, risk-return properties as hedge funds … but without the massive fees."   

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  • Hopefully Anonymous

    Some good writing on this by Blodget and his excellent Wall Street Defense Manual.



    I’d still have James Simon manage my money over a simple computer program if I was able to. Because his sophisticated computer programs are getting the benefit of the bargain from simple computer programs many times every day.

  • Ok, so you have 90% of hedge funds (mutual funds too) failing to beat their benchmarks. Then you have all those who manage their money by indexing. Logic tells you that those who fall into neither category are making tons of money. And one rather doubts that they’re doing that by chance or luck.

  • Dennis, because of management fees, the average of the few fund that make money for clients need not make them very much money.

  • DerekChang

    Of all the blogs out there, it is rich that this article is posted here for all of these studies are subject to massive biases, self-selection bias, survivorship bias, and otherwise. The datasets used by these studies are all based on voluntary submission. Hence, they are unlikely to include all the funds go belly-up. At the same time, they are also unlikely to include places like Renaissance. How this effects the study’s conclusions is anyone’s guess.

  • This is true in a narrow enough sense to be worthless, but what those programs do is allocate assets, not replicate strategies. It’s akin to saying that if you buy the right amount of blue paint, you can be Picasso.

    I’d be interested in how they aim to replicate (for example) the performance of Centaurus, which basically bullied Amaranth into liquidation. I don’t think “Massively ballsy psuedo-manipulation” is an asset class.

  • Dan

    DerekChang: The biases of the sample are discussed in the quoted part of the article. And in any case, the argument being made is that “take the average” strategies outperform hedge funds, and since the most obvious problem with the dataset is the lack of information from badly performing or defunct funds, a more accurate study would most likely bolster the conclusions.

  • ChrisA

    According to an interview in BusinessWeek (July 16th print edition) with Ed Easterling of an Hedge Fund advisor firm the reason that hedge fund averages trail the averages is that they “list their returns in those databases voluntarily, so investors can see them…..Some leave the databases if they’re performing well because they no longer need the exposure. Studies have shown that twice as many funds withdraw from index databases for good performance than drop out for bad.”

    They don’t provide a link to these “studies”.

  • I believe the 2 and 20 phrase and the article’s example is misleading. In the hedge fund LP agreements I’ve reviewed the 20 is inclusive of the 2. Plus, we generally request and get a hurdle, say 8% and a high water mark, which reduces the dollars paid under the “and 20”. Its unclear how Kat’s study incorporated these common fee arrangements.

    I also reccomend Blodgett’s articles on slate.com, which cover this territory without the turgid narrative and boring personalities of the New Yorker’s article.

  • Doug S.

    Well, as more and more hedge funds appear, it becomes much harder for hedge funds to “beat the market” because they start becoming the market themselves. If, on average, one can’t do better than average, the next reasonable question to ask is if the average itself can be improved. One can increase one’s personal wealth both by getting it from others and by creating new wealth. Does stock market “investing” actually create new wealth (in the way that turning steel into cars or writing best-selling novels creates wealth), or does it simply transfer wealth from one set of people to another in a giant zero-sum game (as does the market for Beanie Babies)?

    I’m not even convinced that stock has any meaningful intrinsic value whatsoever. By “intrinsic value” I refer to the value conferred by owning a stock, as opposed to the gains from speculation when one “buys low and sells high.” If you knew that you would never be able to sell shares of a certain stock for more than they were purchased for, would that make the stock completely worthless?

    There seem to be several sources of intrinsic value of a stock that I am aware of. I’ll list therm here.

    1) Dividend payments made out of company profits
    2) Liquidation value of assets owned by the corporation
    3) The ability to vote in shareholder elections and thereby influence corporate decision making

    Assume the following about a corporation:

    1) It pays no dividends and never will pay dividends. All profits earned are reinvested into the company’s business.
    2) Its assets equal its liabilities. Furthermore, its assets will always be equal to its liabilities.
    3) All currently available stock is non-voting stock that confers no ability to influence corporate decisions whatsoever.

    There seems to be no benefit to owning, as opposed to selling, stock in such a corporation. How is the size of a company’s business relevant to a stockholder if it never pays dividends or accumulates assets? If the company does one thousand dollars worth of business or one billion dollars worth of business, the individual shareholder doesn’t get to spend any of it anyway, so what’s the difference? Voting rights aside, why would a permanently dividend-free company ever have a market capitalization different from its liquidation value, and if its liquidation value is zero, then isn’t there no benefit whatsoever to owning the stock?

    The strange thing is, many corporations with valuable stocks actually come close to meeting my criteria for total worthlessness. That’s not to say that they don’t produce useful goods and services – most do – but I don’t see how shareholders benefit.

  • jck

    if all profits earned are reinvested into the company’s business and no dividend is paid, and the corp remains profitable, the assets side increases as does shareholders’ equity, so the corporation isn’t worthless, the balance sheet been: assets = liabilities + shareholdrs’ equity.

  • Henry Blodget’s warnings about the rapacity of Wall Street are well-taken, but any investor worth his salt is quite aware of fees and performance already. And for those who believe in the Efficient Market Hypothesis and/or can’t see what shares (i.e. an ownership stake) in a publicly-traded company are really worth, I highly recommend an essay by a certain fairly-successful investor. (Hint: his initials are WB.) The Superinvestors of Graham-and-Doddsville: http://www1.gsb.columbia.edu/valueinvesting/research/public_archives/DOC032.PDF

  • Dennis-

    The great majority of investors are not smart and just dump money in SEPs, 401Ks, etc, and would never see a hedge fund except indirectly. The greatest quantity of invested funds is owned by people or nonprofit trusts who are not necessarily smart investors, but hire people who are. Bringing this round to the blog-topic, those financial advisors are sympathetic to large fees, because they also charge large fees and a round of recriminations over fees would be unseemly to both.

    I doubt you’d see economic professors telling their own employer school that the stipend/fee demanded by a visiting professor is too high.

    There is some herd mentality to accepting such fees, too (similar to the article you cited that talks of herd mentality in overpricing stock). And a bias that afflicts those who think a car is great BECAUSE it costs $250,000.