A Mystery in Hedge Fund Investing
- Created on Sunday, 22 March 2015 19:00
By Carl Richards
When I look at hedge funds, there are three data points that keep bothering me. They create a pattern that doesn’t make a lot of sense. I hope you can help me understand what I’m missing.
1. Hedge fund performance has been terrible.
In 2014, the Barclay Hedge Fund Index returned 2.88 percent. In that same period, the boring Standard & Poor’s 500-stock index of larger American stocks gained more than 13 percent and the Barclay United States Aggregate Bond Index rose more than 5 percent.
I know, I know, that’s only one year. And one year doesn’t equal a track record. But how about a decade?
For the 10 years ending in January 2015, Vanguard data shows that a basic portfolio of index funds that own every security in a market segment (60 percent stocks, 40 percent bonds) would have returned 6.6 percent a year. The average hedge fund only managed an average return of 5.6 percent a year. In case you’re wondering, the same 60/40 portfolio beat the average hedge fund for three- and five-year periods, too.
We’ve all heard the stories about hedge fund managers who won big and walked away with billions. Although it’s not impossible to identify these fund managers before their big wins, it’s highly improbable. Most of the rest of the people who made a lot of money with them were probably just lucky.
2. Hedge fund expenses are insane.
The amount you pay for an investment has a direct, mathematical correlation to how much money you’ll end up with. John C. Bogle, the Vanguard founder, refers to it as “the relentless rules of humble arithmetic.” The more you pay, the less you keep.
With those “relentless rules” in mind, the typical hedge fund charges 2 percent of assets under management and 20 percent of any gains, though some may charge more or less. Using humble arithmetic, compare those numbers to low-cost, diversified index funds that charge people 0.25 percent (or less, as many do). Now, we’ve reached the point where the data gets really confusing to me. People pay much more and have gotten much less of late when they invest in hedge funds.
3. People continue to invest in hedge funds anyway.
Investors sank more than $88 billion into hedge funds in 2014. Why do people keep doing this?
One assumption might be that they don’t know that hedge funds are just really expensive, underperforming mutual funds for rich people. But given how much people have written on the subject, it’s probably something else.
Maybe hedge funds give people something to talk about at parties. Based on what I hear at different events, some people love sharing the news that they own XYZ hedge fund. It sounds cool, right? Not everyone can invest because of various rules and screenings, so it does convey some sort of social standing, I suppose.
The attraction could also be in the pure entertainment value. Some people enjoy watching ESPN, reading a book or heading outdoors. The really wild people enjoy taking a walk with their spouse or spending time with their children. Perhaps hedge fund investors want the entertainment of buying really expensive things that probably won’t work, on the off chance that they will once in a while.
Or the reason could be more subtle. Americans have a hard time admitting they’re average. Hedge funds have gone out of their way to push the idea that they are better than average. For wealthier people, the desire to claim that golden ticket, to be better than average, may be worth every penny of the insane fees they pay.
Perhaps, however, I’m not giving people who are buying hedge funds enough credit. Maybe they are actually looking for a hedge … fund. You know, something that really and truly hedges against market downturns by betting that certain stocks or market segments will fall. In that case, I can understand the confusion. Given the tear the market has been on, it might make sense to be looking for ways to protect yourself in case of a steep correction.
In fact, that’s what hedge funds were supposed to do in the first place, and there are still funds that do it. You may have to look hard to find them though, because many of today’s so-called hedge funds aren’t really hedges against a sharp drop in the market. They’re audacious, all-in bets on a variety of big market moves or the funds’ fancy computers and software that quickly scrape pennies off transactions valued in the millions. People seeking a true hedge fund need to proceed with caution and make sure a hedge fund isn’t really something else in disguise.
Obviously, I could be totally wrong here. I’m just a guy from the hills in Utah, and this pattern of decision-making could make perfect sense. You may be completely happy with your really expensive, underperforming mutual fund. If so, who am I to burst your bubble?
This commentary originally appeared March 9 on NYTimes.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2014, The BAM ALLIANCE
Rethinking Money, Not as Good or Bad but as a Tool
- Created on Sunday, 08 March 2015 19:00
By Carl Richards
Almost everything we’re taught about money is focused on spending it and saving it. Parents, teachers and even personal finance books discuss saving money as keeping it, increasing it and controlling it. Saving money involves figuring out ways to get more of it, to build a bigger cushion. We’re taught that’s the ultimate goal.
In contrast, spending money is described as budgeting or cutting back. We’re even told that we should create habits that make spending painful, like cutting up credit cards and carrying only cash. We shouldn’t feel good about spending money.
For as long as I can remember, that’s how I’ve defined these two concepts: saving good, spending bad.
Then, there was a subtle change in my thinking. What if we start treating money like a tool? Tools are meant to be used. They’re not meant to sit on a shelf and collect dust. Instead of thinking in terms of saving and spending money, I started to think of using it.
For instance, let’s say we’ve decided that it’s time to go on a family trip. We’ve saved the money, and the trip fits our plans perfectly. When the time comes to use that money, there’s no need to feel guilty or bad. Instead, we’re using a tool that helps us get something that we really value, time with our family.
This shift in thinking is definitely subtle, but it changes our feelings about saving and spending. We no longer need to think in terms of good and bad, positive or negative. We’re focused on the outcome of our actions.
Money is meant to be used, to be in motion. It circulates from us to other people then back to us again. Even when we save money, we’re simply storing it for use later. When we use money today, we’re not spending it or blowing it. We’re using the best tool available to get the job done.
My experience suggests this small shift changes both how we feel and talk about spending. With that change comes a different perspective about what it means to spend money. Of course, the shift doesn’t give us permission to blow the budget or ignore our plans. But it neatly detours around the negative emotions we’ve been taught to feel about spending money.
We don’t feel bad when we use a hammer to pound in a nail. We don’t need to feel bad when we use money to pursue our plans and goals.
This commentary originally appeared February 17 on NYTimes.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2014, The BAM ALLIANCE
Deflation and Stock and Bond Returns
- Created on Sunday, 08 March 2015 19:00
By Jared Kizer
Overview: With expected inflation rates very low, there will be significant attention on the possibility of deflation causing the stock market to fall. This blog examines the relationship between the rate of inflation and stock and bond returns. Generally, the research shows that stock returns are no lower in deflationary environments than in normal inflationary ones. The research does find, though, that both stocks and bonds have done poorly in high-inflation environments.
Expected inflation rates in the U.S. and elsewhere are very low. Figure 1 shows the average annual expected inflation rates in the U.S. over the next one, three, five, 10, 20 and 30 years.
Figure 1
In every case, the expected rate of inflation is less than 2 percent per year and the expected inflation rate is actually –0. percent over the next year. This is far from the norm for the U.S. and indicates that very low inflation or deflation remains possibile.
A frequent, but as we will see inaccurate, assumption is that stocks do extremely poorly during periods of deflation. The argument is that deflation causes people to delay spending because they know prices will be lower in the future, which creates a vicious spiral that harms businesses, the economy and, ultimately, stock prices. Another common, and much more accurate, belief is that bonds tend to do well during periods of deflation. Before we take a look at the data in either case, let’s distinguish between expected and unexpected rates of inflation (or deflation).
Realized inflation can be decomposed into two components:
Realized Inflation = Expected Inflation + Unexpected Inflation
In an efficient market, stock and bond prices should reflect expected inflation and only change in response to unexpected inflation. Therefore, when analyzing the relationship between asset class returns and inflation, it is best to analyze the relationship between asset class returns and unexpected inflation. In addition to using an estimate of unexpected annual inflation in my analysis, I also use real returns instead of nominal returns.
Figure 2 presents the average, maximum and minimum annual real returns over the period of 1928–2013 for the S&P 500 and five-year Treasuries during different unexpected inflation environments.
Figure 2
In the first table in Figure 2, the annual average real return on stocks and bonds is calculated during periods when unexpected inflation is well below average (“20th Percentile or Lower”), around its average (“Between Two Extremes”) and well above average (“80th Percentile or Higher”). For stocks, this table shows that stock returns are roughly similar in the low and average unexpected inflation environments but tend to be lower during high unexpected inflation environments. For bonds, real returns tend to be very high in low unexpected inflation environments and very low in high unexpected inflation environments, as expected.
The second and third tables in Figure 2, however, are worth keeping in mind. While the first table shows what happens on average, these tables show that the range of returns is wide. This simply means that while we have a good sense of what happens on average in each environment, real returns for either stocks or bonds in any given year could be high or low regardless of the unexpected inflation rate.
To put this last point in perspective, Figures 3 and 4 show scatter plot relationships between real stock returns and unexpected inflation (Figure 3) and real bond returns and unexpected inflation (Figure 4).
Figure 3
Figure 4
The primary takeaway from Figure 3 is that the relationship between real stock returns and inflation is a weak negative correlation. The general tendency is for stock returns to be higher in low unexpected inflation environments and lower in high unexpected inflation environments. This relationship, however, is not particularly strong. Said differently, as the tables in Figure 2 also show, it is entirely possible for stock returns to be high or low in any given inflationary environment.
Figure 4 shows a much stronger negative correlation relationship between bond real returns and unexpected inflation. Compared with Figure 3, the plot points in Figure 4 are more closely clustered around the trend line. By knowing the unexpected inflation rate in a particular year, you can fairly accurately guess how bonds did that same year.
Overall, these results show that stocks by no means do poorly during periods of low unexpected inflation. On average, stocks have done very well during periods of low unexpected inflation and worse in periods of high unexpected inflation. Bonds show similar tendencies but with a much stronger connection to unexpected inflation.
This commentary originally appeared January 30 on MultifactorWorld.com
Jared Kizer is the chief investment officer for the BAM ALLIANCE. See our disclosures page for more information. Follow him on Twitter.
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2014, The BAM ALLIANCE