"Kee" Points with Jim Kee, Ph.D.

Markets responded positively to some of the better global news last week, like Sunday’s release of rather positive European bank stress tests and China’s economic numbers indicating 7.3% GDP growth for the third quarter. The Conference Board’s Leading Economic Index (LEI) for September was also released last week, and it came in at a solid .8% gain. The index is made up of 10 indicators, and 9 out of the 10 were up in September (versus just 5 out of 10 in August). That is called the “diffusion” index, and it is important because any given individual component can be distorted on a month-to-month basis, and this can distort the LEI. But if the diffusion index is high (above 50%), then any given LEI reading has more validity. The credit component was the strongest contributor last month, reflecting improving credit conditions (i.e. availability of and demand for credit).

 

Hedge funds: But one of the more interesting things that caught my eye in the news last week was an article pointing out that pension fund managers are “rethinking” their investment in hedge funds, following the well publicized decision by CalPERS (California Public Employees Retirement System), the nation’s largest pension fund, to get out of hedge funds entirely. Hedge funds are investment vehicles available to “qualified” investors--individuals or institutions meeting certain minimum income and net worth requirements. There are a wide variety of hedge fund strategies (e.g. event driven, global debt, equity, arbitrage, macro) that invest in just about everything including stocks, bonds, currencies, futures, etc., and often involving potentially high risk strategies involving derivatives, short selling, and the use of leverage (using borrowed funds to enhance gains – or losses!). Hedge funds are little regulated (almost none prior to Dodd- Frank), typically have high fees (1.6% of assets and 18% of any gains, on average, according to the Wall Street Journal), have little transparency, and often have low liquidity (money is “locked up” to varying degrees). Often considered the “yacht club” of investing (La Jolla Economics), hedge funds are also known for some of investing’s most spectacular crashes, like the implosion of Julian Robertson’s (i.e. “the Wizard of Wall Street”) $20 billion Tiger Management in the 1990s, and the collapse of Long-Term Capital Management which required a bail out by the Federal Reserve.

 

Hedge funds promise low correlation to other markets, and often deliver it, including lower downside risk. For example, hedge funds declined less than other market indices during both big market declines 2000-02, 2007-09, and 2011 (Crandall Pierce; Bloomberg). Some of this is a bit overstated as hedge fund indices don’t fully account for “survivorship bias” (the fact that hedge funds that go under often go underreported) and “backfill bias” (only those who choose to report are included in hedge fund indices). And as mentioned above, the fees are substantial. But perhaps more importantly, hedge funds lag during up markets, sometimes by a lot! For example, during 2013 when broader market indices averaged above 33%, the HFRI Hedge Fund index returned 9%. During the 2009 rebound in which stocks gained over 35%, hedge funds were up only 11.5%. And during the similar rebound in 2003 when stocks returned over 26%, hedge funds gained 11.6%. In fact, Crandall Pierce has calculated the average annual return of 16 asset classes – stocks, bonds, real estate, commodities, etc. – going back to 2000. Hedge funds came in second to last at 4.1%, just above Treasury Bills (1.8%). In fact, and somewhat surprisingly, research at La Jolla Economics and published in the Financial Time’s book, Understanding Asset Allocation, showed that the great contribution of various hedge fund strategies to investors comes from reduced volatility, not higher returns. The book’s author also found that hedge funds tend or seem to run in cycles, outperforming when large cap stocks underperform, and visa-versa (similar to small cap stocks).

 

Conclusion: Modern finance can be summed up as follows, “don’t talk about returns without talking about risk in the same sentence.” So the question regarding hedge funds is, do they earn higher “risk adjusted” returns, or returns per unit of risk, than just owning stocks? Princeton’s Burton Malkiel, writing in the Financial Analyst’s Journal, argues that hedge funds are far riskier and provide much lower returns than is generally believed. And Yale’s David Swenson, whose 2000 book on portfolio management kicked off the whole alternative investment movement, in my opinion, has argued that an individual investor being able to earn higher returns on a risk-adjusted basis with hedge funds is nearly impossible. I would say that this is all fairly consistent with the balance of most of the peer-reviewed research (particularly when looked at after fees). The primary benefit of hedge funds appears to be low correlation with other asset classes, though the correlations seem to vary by time period and to lack consistency within a time period. Offsetting this is the lack of transparency, the high fees, the low liquidity, and the lost upside in strong markets. These are the costs of that low and unstable correlation, and whenever I look into hedge funds I am struck by this rather underwhelming attractiveness. But it is the general opaqueness of hedge funds that I find most surprising …the fact that so many institutions put so much of their clients’ money in them without really knowing what they do.