daily volatility, non-correlation …and beta (ii)

This post is about hedge funds.

hedge funds:  a purist’s view

To a purist, a hedge fund is about hedging.  That is, it’s about running a portfolio with offsetting long and short positions.

Conceptually, this can be done either by assembling pair trades (one long, one short, often both in the same industry) or by creating opposing portfolios of good ideas and clunkers.  By using the money obtained from borrowing, and then selling, the hoped-for clunker stocks to fund the hopefully strong-performing good ones, the hedge fund manager ends up with no net exposure to the securities market he’s working in.  His return consists in the spread, if any, between the performance of the aggregate long portfolio and the shorts.  In a perfect world, he never loses money, although the amount he makes in a given year is up in the air.  It depends on the relative valuations of the “good” and “bad” securities that his market gives him.

(By the way, I worked on, and briefly ran, a very successful short-only portfolio for an innovative institutional client in the early 1980s. We pruned “bad” stocks from an S&P 500  index fund and reinvested the money in the rest of the index.)

today’s version

In today’s world, hedge funds are a motley group of mostly strongly net long, mostly highly concentrated portfolio strategies.  They do have common characteristics, though.  They charge very high fees, and as a group they’ve underperformed the S&P 500 pretty continually for more than a decade.  Also, many times it’s hard to get your money back if you no longer want to participate.

why institutional support, despite weak returns?

Why do pension funds continue to support hedge funds with a tolerance for weak performance they would never exhibit with long-only managers?

Two reasons:

–the claim of non-correlation with stocks and/or bonds.  This is basically a rerun of the fallacy of gold as a zero-beta asset, and

–the low expected return from stocks and bonds.  To pluck numbers out of the air, let’s say that over the next five years we can expect returns of 2% annually from bonds and 6% from stocks.  A portfolio made up of equal portions of both asset classes would have an expected return of 4% per year.  Suppose the actuarial assumption of a plan sponsor is that the plan is fully- or mostly-funded if the plan can achieve of 5% annual returns–or maybe 6%.  The plan managers, who hire outside portfolio help, have no way of get to either goal using conventional long-only investments.  That’s even going all in on stocks, which sponsors find too risky.  So the managers can either tell the sponsoring organization to add more money to the pension plan   …or they can hire hedge fund managers with pie-in-the-sky stories of high potential returns.  Until very recently, my observation is that they’ve by and large chosen the latter.





why do pension plans choose hedge fund and private equity managers?

private equity

Mitt Romney’s presidential candidacy has created a new wave of interest in the mechanics of private equity.

The debate has so far primarily been about whether what private equity does–take control of companies that are not making much money, reorganize them and sell them on–is socially useful.  The answer is generally “Yes.”

A secondary question is whether investors in private equity funds, primarily pension plans and university endowments, are getting a good deal. The answer here is generally “No.”  In a recently conducted study for the Financial Times, for example, professors at Yale (whose endowment has been a bastion of such “alternative” investments) and Maastricht University conclude that the vast majority of profits go to the organizers and promoters of private equity schemes, not to the investors who bear almost all the risks.

hedge funds

The same is true of hedge funds, which incidentally are putting the finishing touches on a decade of underperformance versus an S&P 500 index portfolio.  And that conclusion is based on the data the funds themselves voluntarily report.  There’s lots of evidence that some hedge funds routinely overstate their: investment performance, assets under management, and the size and qualifications of their professional staffs.

these are illiquid investments

…oh, and in addition to less-than-stellar profits, these vehicles can be highly illiquid.  In the Great Recession, investors in hedge funds learned to their dismay that the contracts they signed (which they apparently hadn’t read) allowed their managers to refuse requests for redemptions–even for years.  Recently, stories have also been circulating about failed private equity projects that refuse to liquidate, presumably because that would put an end to the management fees the organizers are collecting.

but they’re in high demand

That such a P.T. Barnum-esque situation should have developed with exotic investment vehicles isn’t that strange.  What is, however, is that despite a long period of lackluster performance, institutional investors want to put more of their money into hedge funds and private equity, not less.

Why is this?


The standard answer that institutions will give is that these “alternative” investments aren’t correlated with the movements of stocks and bonds.  Therefore, they’re a diversification.   That lowers the risk of the overall institutional portfolio.

This, of course, is not true.

Generally speaking, the fact that the returns on two assets aren’t correlated doesn’t mean that the risks of one partially offset those of the other.  It just means that you’re exposed to two different sets of risks.  The fact that in bad weather you speed in a racing car and pilot a small plane doesn’t mean you’re safer than if you just did one of the two.

Also, in the case of alternative investments, there’s no public market and holders have no independently verified information about their returns.  So they have no way of determining if risks are correlated or not.

political pressure

A second, less talked-about reason is that hedge and private equity funds hire powerful, politically connected, salesmen who wield influence over the pension plan managers.  There have been scandals about payments to such sales agents in California and New York.

damned if they don’t

To my mind, the main reason institutional investors are attracted to alternative investments is simple arithmetic.  Traditional pension plans don’t have all the money on hand today that will be needed to pay their future obligations to present and potential retirees.  They assume that they can invest the funds they do have to earn a specified return, usually around 7%, so that today’s assets can grow enough to meet future obligations.  If they can’t do this, the plan is underfunded and the employer has to eventually kick in enough to make up the difference.

Is 7% a reasonable annual rate of return in today’s world?  Not if you’re limited to publicly traded stocks and bonds.

Let’s say that you have a 50/50 mix of the two asset categories.

–Stocks can probably have a nominal return of 8% a year (inflation +6%).  History says that in the aggregate the managers you hire will deliver somewhat less than that.

–The 30-year Treasury is yielding about 3%; the 10-year yields about 2%; the return on cash is practically zero.  Interest rates are now at emergency-low levels.  This means chances of a capital gain from holding bonds are slim; chances of a capital loss on your bonds as the economy recovers and rates rise are high.  Let’s be super-optimistic and say you can collect a 3% coupon and make no losses.

With a 50/50 mix of stocks and bonds, then, a pension plan can achieve a return of about 5% annually.  That’s nowhere near enough to meet the 7% goal.  Even if the plan went to an allocation of 100% stocks,  it might not achieve a 7% return.  And doing so would give up all protection against the possibility that another year like 2008 rolls around–as one sooner or later will.

How does the executive in charge of the pension plan deal with this problem?

Does he go to his boss and say he needs an extra $10 billion or so to fund the plan–taking the risk that the boss will shoot the messenger?   …or does he take the chance that, against the testimony of experience, alternative investments will deliver what they promise–big enough returns to get to the 7% goal?

The latter is certainly the path of least resistance.  And this fact also probably makes the political pressure from the hedge fund/private equity salesman that much harder to resist.