Hedge Fund Follies

Tail-Chasing
FundFire's headline (which you won't see, it's a paywalled site) tells the story: Wirehouse Advisors Drop Hedge Fund of Funds. Hedge funds of funds, or HFOFs, came into fashion in the middle of the last decade. At that time, hedge funds had terrific track records, as most of them had dodged the 2000-02 technology stock crash. They were dangerous to buy individually, though, because of their investment leverage and their risk of fraud. Thus, the vehicle of choice for institutions and high-net-worth investors became the HFOF, which promised not only to find the best hedge fund managers but also to weed out the frauds.

The results have been weak, to say the least. Over the past seven years, multistrategy HFOFs have limped to a 0.75% annualized gain in Morningstar's database. (The official figure overstates the record. As self-reporting entities, hedge funds have the luxury of being able to pick and choose when to divulge their performance. Naturally, they tend to report when doing well and disappear when they are faring poorly.) In contrast, every flavor of target-date mutual fund has gained more than 4% over that same time period.

Let's review. Institutions and wealthy informed buyers did their research and selected a high-cost, opaque, complex investment. Poor, uninformed buyers did little research at best and landed in a low-cost, transparent, simpler (if not simple) investment. The 2008 financial markets delivered the massive bear market that the high-cost instrument was designed to resist and the low-cost instrument was not, dealing the low-cost investment such losses that the U.S. Senate held hearings on the subject in 2009. Yet the easy winner since the middle of last decade has been the low-cost instrument. Funny how that works. 

Not only did target-date funds outgain HFOFs over that stretch on paper, but they also were better used by their owners. Cash flows into target-date funds have been steadily positive, year after year. As a result, Morningstar Investor Returns (see PDF link for an explanation of that calculation) for target-date funds are higher than the funds' actual returns; that is, there was more money invested in target-date funds when they were rising (that is, post-2008) than when they were sinking (2008). Not so much with HFOFs. They received inflows in the mid-2000s following good returns, had poor absolute and relative returns when they were at peak assets, and are now leaking cash.

It's not just HFOFs. Take a look at the recent net flows into systematic-futures hedge funds (sometimes called managed futures), accompanied by the category's average rate of return that year and the performance of the S&P 500.  

An almost perfect record of inept tail-chasing. Money flowed into systematic-futures funds in 2006. The funds trailed stocks that year. Next year, as money was leaving, the funds beat stocks. The next year, presumably because of 2007's good performance, cash flows reversed and money came back into the category--which had a career year, gaining 18% even as everything else went down. (The year 2008 was the lone exception to ineptitude.) Following this bang-up showing, cash flows were positive three years running, even as futures funds badly trailed stocks. Finally, after suffering through that long period, investors started to give up on the category, yanking money out last year and again so far this year.

These are not isolated incidents. Hedge funds allegedly are held for diversification, but in practice they tend to be purchased and evaluated on performance. Because they behave quite differently from other assets, they frequently lag the rest of a portfolio's holdings--thereby inducing the frustrated institutional or high-net-worth investor to swap that hedge fund for another flavor. Hedge funds, in addition to being expensive, are deucedly difficult to own. 

It doesn't make much sense to me that becoming wealthier and more informed leads to worse investment results ... but with hedge funds, that does indeed seem to be the case. 

Lies, Damned Lies, and Taste Tests
A brand called Purity Vodka is running an advertisement boasting that, when given a blind taste test, one in two Grey Goose drinkers preferred Purity. Wow. Think about that. Not only do Purity's own drinkers prefer Purity, but half of a rival brand's drinkers do, too. That must be one tasty vodka.

Do you see the trick? Almost nobody can tell the difference between two premium, unflavored vodkas--they're supposed to be tasteless, for goodness' sake. So, if you give 100 Grey Goose drinkers a blind taste test of the two vodkas, about 50 will choose one brand and 50 will choose the other. The same would happen if you selected 100 Purity drinkers.

This con and others is covered in Charles Wheelan's new book, Naked Statistics, which I recommend highly. Among the book's many instructive and entertaining examples is the 1981 Super Bowl ad wherein Schlitz conducted a live blind taste test with 100 Michelob drinkers to see if, gasp, some of those Michelob drinkers might prefer Schlitz. As it turns out, gasp, 50 of them did. Perhaps Naked Statistics jarred the memories of Purity's marketers?

Naked Statistics is a good book for those who know statistics and good book for those who do not. For those trained in the field, Naked Statistics is nonetheless useful for illustrating the ways in which numbers can be used for marketing effects, as well as blindly misused. For those who are foggy on the subject, then now is the time. There's no easier or enjoyable way to learn the joys of distributions, standard errors, and t-statistics--and to learn the practical application of such concepts when reading the many media articles that report on statistical findings.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.