dismal

2013: Another Dismal Year for Hedge Funds

dismal

“We active folks have done a horrible job of beating the benchmarks.” So says Bob Doll of Nuveen Investments who was recently interviewed by Jeff Macke of Yahoo! Finance’s Breakout. For 2013, there is one group of active managers for whom this was especially true—hedge fund managers. According to Bloomberg, only 16 of the 100 top-performing hedge funds beat the S&P 500 Index (based on returns as of October 31st). Furthermore, hedge funds as a whole returned an average of 7.4% in 2013, trailing the S&P 500 which returned 32.3%. Actually, “trailing” does not seem like a nearly strong enough word for this situation. Adding insult to injury, 2013 was the fifth consecutive year where the hedge funds failed to beat the most ordinary of stock indexes. While some hedge fund advocates may correctly protest that the S&P 500 is not the benchmark chosen by most hedge funds, it nevertheless has to be a source of frustration to shareholders who thought they were gaining entrée to superstar managers whose talents were unavailable to the general public.

The 2013 numbers are now in for Warren Buffett’s million-dollar-bet on the S&P 500 against a collection of hedge fund of funds chosen by Protégé Partners, and his lead has considerably widened from 8.6% to 31.3%. The odds of the hedge funds reversing this in the next four years are very small indeed. Although Mr. Buffett has never accepted the notion of market efficiency, he has nonetheless been one of the most powerful and consistent voices in favor of indexing for many years now. If the Oracle of Omaha doubts that even a professionally selected group of hedge fund managers can both cover their costs and deliver an above-market return to their shareholders, ordinary investors (including “qualified investors”) should think twice before playing the mug’s game of manager picking.

The underperformance and other problems of hedge funds are topics that we have covered in many different articles. One story that we followed quite closely in 2013 was the unprecedented indictment followed by a guilty plea and a record $1.8 billion fine for billionaire Steven Cohen’s SAC Capital. Although he is facing civil charges for failure to supervise his employees, Mr. Cohen himself has still managed to elude prosecutors while his underlings face the music. One of his portfolio managers, Mathew Martoma, was just convicted of insider trading, and prosecutors showed that Mr. Martoma called Mr. Cohen before dumping $700 million of two pharmaceutical companies after receiving an insider tip on a failed Alzheimer’s drug trial.

If you have read many of our articles about manager picking, then you will likely know that we use the technique of statistical testing (Student’s t-test) to determine if historical returns are explained by luck or skill. The basic premise is that if we can rule out luck with at least 95% certainty, then skill can be accepted as the explanation (although there is still up to a 5% chance that it is luck). However, our experience with hedge funds has taught us that this is simply not the case. If we rule out luck (or randomness), that still leaves open the possibilities that the returns are simply fraudulent (e.g., Madoff and his feeder hedge funds such as Fairfield Greenwich Group) or that they were achieved through illegal activities (e.g., SAC Capital).

It has been about two years since Simon Lack published The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to Be True, and everything that he exposed about hedge funds continues to be borne out. As we said before, anyone who is either currently a hedge fund investor or is contemplating becoming one would do well to read his book.