Tough Times for Alternative Investment Strategies and Hedge Funds

Tough Times for Alternative Investment Strategies and Hedge Funds

Tough Times for Alternative Investment Strategies and Hedge Funds

At Index Fund Advisors, we are always distressed when we read articles such as this one that discusses a state pension plan increasing its exposure to alternative investments (i.e., investments beyond stocks, bonds, and real estate such as hedge funds and private equity). Two recent articles1 in the Wall Street Journal concerning the performance of alternative-based mutual funds and hedge funds support our position. One of the articles notes the recent growth of alternative-based mutual funds from about $36.4 billion in assets in 215 funds at the end of 2008 to $150.1 billion in 442 funds at the end of April, 2014. Using data from Morningstar, the author reviewed the returns of five different categories of alternative funds:

1)      Long/short equity

2)      Multialternative

3)      Market neutral

4)      Managed Futures

5)      Bear Market

While we were somewhat confused about the difference between long/short equity and market neutral, a little digging revealed that long/short equity funds are not required to offset every long position with a short position, so they can still have net market exposure. One category that may appear to be missing from the above list is “absolute return”. As far as we are concerned, M. Barton Waring and Laurence B. Siegel summarized it perfectly when they said, “The term ‘absolute-return investing’ has no meaning—it misleads the investor into thinking it has substance that it does not have, and in our opinion, the term simply should not be used.”2 Morningstar appears to agree, as they explain in this press release, “Absolute Return as a fund category definition has become too associated with a broader industry marketing term that has made performance promises that have often failed to deliver."

For the five years ending 5/31/2014, the S&P 500 Index delivered an annualized return3 of 18.4%. None of the five alternatives even came close. The best of them was long/short equity at 9.2%, and that probably came from the net long exposure of most of those funds. In second place was the nebulous category of multialternative at 5.2%, which again, probably derived from a net long exposure to the market. In third place were market neutral funds at 1.6%, about the same as short-term bond funds. Investors in market neutral funds should not complain since they should be fully cognizant that there is no way to avoid market risk without giving up market returns. In fourth place were managed futures funds at -2.6%, about equal to the zero expected return of futures minus the costs of running the funds. Why any investor feels compelled to have those in his portfolio is simply beyond us. Finally, last and certainly least were bear market funds with a frightening annualized return of -27.1%, which would have turned a dollar into 21 cents. As far as ideas go, betting against the market is right up there with sticking your head in the lion’s cage or going hiking in Afghanistan.

Regarding the cesspool that is today’s hedge fund industry, the second of the two WSJ articles demonstrates continuing disappointment for investors but certainly no disappointment for hedge fund managers, the 25 highest paid of whom took home an average of $840 million, according a report from Institutional Investor’s Alpha. Hedge funds now manage more than $2.4 trillion vs. $865 million a decade ago, according to Hedge Fund Research (HFR). HFR’s composite index of hedge funds has returned 72% over the ten years ending 5/31/2014 while the Vanguard Balanced Index Fund (60% Total U.S. Stock Market and 40% Total U.S. Bond Market) has returned about 100%. As Simon Lack pointed out in The Hedge Fund Mirage, hedge fund investors as a group have done about as well as if they had invested in Treasury Bills. The managers and providers of seed capital to hedge funds, on the other hand, have done quite well for themselves.

The author of the WSJ article cites some interesting work by economists Jakub Jurek of Princeton University and Erik Stafford of Harvard Business School. Specifically, they showed how hedge fund performance from 1996 to 2012 can be replicated through a strategy that involves generating income by selling out-of-the-money put options. Without getting into too much detail, suffice it to say that this strategy works beautifully (additional income with no additional volatility) until it stops working after the market takes a steep enough decline to allow the put options to be exercised against you. Andrew Lo of MIT thought up a humorous name for such a fund, “Capital Decimation Partners.”

For well over a decade, Index Fund Advisors has been warning investors to steer clear of hedge funds. To emphasize the point, we even came up with our Hedge Fund Manager Hall of Shame that appears in this article about SAC Capital and its insider trading indictments.

If the trustees of state and municipal pension plans don’t want to listen to us, maybe they should direct their attention to Warren Buffett. According to this article, Mr. Buffett was asked (via letter) by a board member (Herb Meiberger) of the $20 billion San Francisco Employees Retirement System whether a proposal to have a new 15% allocation to hedge funds should be passed along with permission to generate income by selling options. Here is the Oracle’s terse response scribbled at the top of the letter:

“Herb—I would not go with hedge funds—would prefer index funds and not sell options around equity positions.”

It seems that Mr. Meiberger now has some powerful ammunition to use at the next board meeting. He can also point to the current status of Mr. Buffett’s bet in favor of an S&P 500 Index Fund over a collection of hedge funds picked by a professional hedge fund picker (Protégé Partners). As of year-end 2013, the index fund was beating the hedge fund collection by a nearly insurmountable 31.3% margin.

To summarize, hedge funds and alternative investment strategies are simply one more way for the sharpies of Wall Street to pick investor’s pockets. Our best advice is to stay far away.


1Maxey,Daisy, ”Different, Yes. Better? Not Lately.”, Wall Street Journal, 6/3/2014 and Lahart, Justin, “Hedge Funds Investing Prowess Doesn’t Live Up to Billing”, Wall Street Journal, 5/26/2014.

2Waring, M. Barton and Laurence B. Siegel, “The Myth of the Absolute-Return Investor”, Financial Analysts Journal, March/April 2006.

3All the returns in this paragraph are from Morningstar Direct (accessed on 6/9/2014).