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IFA's Quote of the Week - 18

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"Some fiduciary boards, particularly those composed largely of non professionals, do not adequately understand the true returns, risk and cost associated with investment in hedge funds."

“Statement of the Financial Economists Roundtable on Hedge Funds,” Stanford Graduate School of Business, 2005.

 

 

 

In July 2005, a group of 32 distinguished economists met in Sonoma, California to discuss the risks and benefits of hedge fund investing. The eminent economists, including renowned professors from London School of Economics, Wharton, Stanford, Cornell, and UCLA, to name a few, as well as Nobel Prize winners and Federal Reserve Bank economists convened to discuss the pros and cons of hedge fund investing for institutions and wealthy individual investors. Their goal was to develop a cohesive statement to reflect their collective views regarding these increasingly popular, but unregulated investment vehicles.

Hedge funds have grown rapidly in recent years and are now about one-eighth the size of mutual funds, accounting for more that $1 trillion of assets invested today. Unregulated by the SEC, hedge funds fall under the category of limited partnerships, enabling them to disclose less information, and incorporate more aggressive investing strategies because their clients are considered to be “sophisticated investors”.

The Financial Economists Roundtable (FER) expressed concern that the rapid increase in popularity of hedge funds has fiduciaries and plan sponsors leaping into investment without fully understanding the risks associated with them. As such, they set forth their signed statement, delineating their concerns regarding hedge funds.

Based on their findings, we have compiled:

IFA’S TOP TEN REASONS TO AVOID HEDGE FUNDS

  1. "Hedge funds investors do not fully understand the true returns nor the risks they bear."
  2. "Hedge funds can employ leverage, thereby amplifying the variability of outcomes."
  3. "Hedge funds restrict redemptions so investment is largely illiquid."
  4. "Their management expenses are very high and their investment strategies are often risky with a small probability of very large losses."
  5. "The asymmetric fee structure creates an incentive for the general partner to adopt a high-risk investment strategy, since he/she stands to make a large return if the strategy is successful but not to suffer losses if the strategy fails."
  6. "The average life of a hedge fund is only about 3 years."
  7. "Expenses are high. The management fee to the general partner usually is 1 to 2 percent of assets, payable annually, and there often is an asymmetric performance fee in addition. This incentive, or carried interest, fee usually is 20 percent, and is often structured to be paid only if cumulative returns over time exceed a threshold return, known as the ‘high-water mark.’ When cumulative returns fall below this mark, the general partner can close the fund, then start a new one in order to establish a new base mark for generating performance fees."
  8. "The returns on many hedge-fund strategies are not normally distributed, but have a distribution characterized by fat tails...day by day there is a small probability of a large loss. Tail risk makes standard measures of return volatility and performance, such as the Sharpe ratio, inappropriate guides to investors. By its very nature, tail risk is difficult to measure."
  9. With the tail and exit risks involved, together with a lack of transparency, the FER has concerns about "whether a large exposure to hedge funds is appropriate for pension funds and other fiduciary investors who make investments on behalf of others, particularly retail investors."
  10. "Risk-adjusted average returns tend to be overstated, because of survivorship bias and other reporting and data problems, making it difficult to compare hedge-fund performance with competing alternatives."

 

The FER’s Executive Summary recommends:

  • Banking regulators should NOT rescue troubled hedge funds. Their justification is that the prospect of free government "bail-out" insurance will only encourage speculative behavior.
  • The development of a standardized measure of performance and risk to foster a deeper understanding about the real volatility and returns associated with hedge funds. They stated, “There should be standardized measures pertaining to gross and net returns, expense ratios, leverage, volatility of returns, credit risk and liquidity.”
  • In-depth research to determine the impact of an asymmetric fee structure on investment behavior.

 

Finally, the 32-member FER concluded that even if each of the recommended measures were implemented, they would still advise a stance of “buyer beware” or "Caveat emptor" when it comes to hedge funds investing. 



If On The Chart It Doesn't Sit, Don't You Dare Buy It

The chart below represents Harry Markowitz’s Efficient Frontier, also known as a Risk Reward Optimization Chart. This simple, yet profound chart earned Markowtiz the Nobel Prize in Economics in 1990, along with William Sharpe (who is a member of the FER), and Merton Miller. The x-axis represents the risk of an investment, as measured by standard deviation of returns. The y-axis represents the reward of an investment as measured by annualized returns.

On this chart are plotted the 35-year risk and return characteristics for IFA’s 20 Index Portfolios (numbered sequentially 5-100), as well as for the 15 IFA Indexes (circled letters) and four market indexes tracked by IFA (squares), but not included in the Index Portfolios. (You can also view the 80-year, 50-year and 20-year Risk Reward Optimization charts by clicking on the menu on the right-hand side of the dynamic chart.)

As you see, we compare our IFA Index Portfolios and IFA Indexes against the Total Market Index, the S&P 500 Index and the NASDAQ Index. We can also plot other indexes and individual stocks on this chart to compare them against one or all of our index investments. However, you cannot plot a hedge fund on this chart. Recall the FER determined that hedge funds are not normally distributed. Head-to-head comparisons cannot be made between non-leveraged, transparent equity investments and leveraged, illiquid and opaque investments that carry risks not represented by standard deviation alone. 

The risk reward optimization chart is the cornerstone of fiduciary prudence and Modern Portfolio Theory. Fiduciaries should never make an investment they cannot plot on this chart. And, given the abundance of prudent investments that carry ample risk and return data, they have no reason to do so.

Index funds are the ideal way to implement fiduciary prudence. They carry ample risk and return data. They are liquid, transparent, carry low fees, no leverage and no performance incentives. Best of all, your investment decisions will carry 80 years of risk and return data so you invest according to the laws of probability, not speculation.

Index Funds Advisors matches individuals and institutions, including corporations, foundations, endowments and perpetual care entities, with risk-appropriate blends of indexes that have shown to deliver risk-optimized returns over time.  To learn how you can implement a low-cost, risk-appropriate, passive rebalancing indexing strategy, click here.