The Financial Analysts Journal

The Financial Analysts Journal is the flagship publication of the Institute of Chartered Financial Analysts.  The ICFA is a trade association of financial professionals that focuses on academic theories of the financial markets.  Although the FAJ has an occasional piece by a professional money manager, it contains mostly the kind of journal articles that university professors need to write for each other so they’ll get tenure.

the January/February 2011 issue

The lead article in the January/February 2011 issue is called “The ABCs of Hedge funds:  Alphas, Betas and Costs.”  The authors divide the hedge fund universe into nine different strategies and analyse the returns of each strategy over a long period of time.  They conclude that for each of the eleven years ending in 2009, every one of the strategies produced “positive alpha,” that is extra returns for investors above their benchmark indices.  These extra returns remained even after deducting management fees and after adjusting for the risks (like financial leverage) that the investors were taking.

This is a stunning result.  It’s by far the most positive assertion I’ve ever heard about the hedge fund industry.  A more usual observation would be that you would have been better off since 2003 by holding an S&P index fund than by giving your money to the typical hedge fund manager.  What’s also remarkable is that there are not just a select few outperforming managers.  According to this study, just about everybody is a hero.

What’s also a bit surprising, given the academic bent of the publication, is that this result flies in the face of the academic dictum that sustained outperformance, year after year, is impossible–and the FAJ makes no fanfare about this.

too good to be true?

Turning to the real world, my personal experience is that what the article says can’t be done.  I’ve known a few managers who’ve strung together long series of outperforming years.  Invariably, they stray from their professed styles or take hugely concentrated positions (say, 20% of the portfolio in one stock) that conventional risk measures don’t capture, to keep their strings intact.  In one (amusing) case, the manager got his clients to agree to a defective benchmark, one that 95% of the entrants in his category could consistently beat.

my opinion:  yes!

I think that what the article says is just too good to be true.  True, I’m not a hedge fund fan.  Maybe I’m jealous of the high fees hedge fund managers get to charge.  But as a group they remind me of the oil and gas tax shelter purveyors I analyzed (among other things) in my first stock market job.   Those vehicles appealed to the egos of the limited partners, who could brag that they had a tax problem, but had lots of snake oil and little investment merit.

Other than pure prejudice, the one observation I’d make about the ABCs study is that it uses returns that are voluntarily reported by the hedge funds themselves and not independently verified.  I’ve written about this practice before.  Basically, it seems hedge funds often inflate their returns when they report them to consultants.

In fact, the February 2010 issue of the CFA Digest, a very handy publication, also from the ICFA, that summarizes important academic articles, cites research published in the Journal of Finance in a piece titled “Do Hedge Fund Managers Misreport Returns?  Evidence from the Pooled Distribution.”  Short answer:  YES. The same issue cites a second article, this one from the Review of Financial Studies. It’s called “How Smart Are the Smart Guys?  A Unique View from Hedge Fund Stock Holdings?”  Its conclusion:  hedge funds outperform mutual funds in stock selection but subtract all that extra value, and more, through higher fees.

That’s more like the hedge funds we all know and …well, that we all know.  (What was the FAJ thinking?)