Don't believe the Hedge

Make money regardless of the economic conditions, word is bond fam. Using short/long/derivative/option/leverage/alternative/private equity/forex swab strategies- the list to riches is long and lavish dawg. Da most sophisticated homies in da game gonna outperform the market in every possible scenario and reduce ya risk yo.

Could it be so easy? Watch ya step. If the above sounds ridiculous, it's because it is. Yet this is a promise hedge funds expound like it was decreed by God to Moses. In 2014 so far the average hedge fund has underperformed in the rising bull market. In 2013 they returned an average of 7% while the S&P 500 index had a 29.1% return with dividend reinvestment. What perpetrates the hedge fund hype is overconfidence and affluent investor’s appetite for sophistication.

Let’s start with the halo effect and overconfidence. Here is list of Wu-Worthy hedge fund managers. It is a short list relative to the approximate 10,000 active hedge funds. The list of 21 successful hedge funders is not representative of all the successful hedge funds but mainly the exclusive ones. So what about the less exclusive hedge funds? Well as Josh Brown put it, in a stroke of statistical and empirical genius, “The odds of identifying an emerging manager from the ground floor who becomes Paul Tudor Jones are about the same as you making out with Kate Upton in an outdoor shower on a Tahitian beach”. This goes a long way in explaining why the average hedge fund has turned in a meager 3.9% return in 2014, doesn’t it. This is, of course, before you consider the standard 2% management fee and 20% performance fees- you didn’t think this was easy did you?

With the paltry recent returns hedge funds have generated it is insane their fees are so high. Especially when considering better returns and lower fees can be found in broad indexes. Paying high management fees for hedge funds is like tipping the register-clerk, who does nothing but take your money, at Chipotle. You wouldn't do that shit at McDonalds, tho they prolly deserve it. Don't even get me started on 20% performance fees- that's like saying "here you were so good at taking my money, have some more". 

Again, to be fair, there are hedge funds justifying rich fees. Alpha Attribution fleshes this out with a chart on the annualized return over the most recent three-year period, that they can roughly pin-point to value delivery.

Top Managers Demonstrating Consistent Stock Selection Skill over Last 3 Years

Fund	Annualized Security Selection Skill	Regulatory AUM	% of Reg AUM Disclosed in Public Filings
RA CAPITAL	43.8%	1.5 BN	51%
SRS INV. MANAGEMENT	25.1%	3.6 BN	67%
COLUMBUS HILL CAPITAL	16.0%	1.7 BN	61%
SCOPIA CAPITAL	13.6%	7.1 BN	35%
HOUND PARTNERS	12.7%	3 BN	77%
BRENNER WEST CAPITAL	11.9%	1.5 BN	60%
SENATOR INV. GROUP	11.1%	11 BN	85%
NEW MOUNTAIN VANTAGE ADV.	8.7%	2.4 BN	88%
LOCUST WOOD CAPITAL ADV.	7.4%	780 MM	90%
STEADFAST CAPITAL	7.4%	8.1 BN	64%
EGERTON CAPITAL	6.8%	10.7 BN	59%

Source: Alpha Attribution

The premise is built on disclosure and *gulp honesty. If RA Capital Management holds Achillion Pharmaceuticals (ACHN), which they do, and it increases by 15%, which I made up, but the biotechnology sector as a whole increases by 10% (made up) then they delivered 5% of value (the difference). This contributes to the 43.8% you see as their Annualized Security Selection Skill. Check the full study here. However, in a cruel twist of mean reversal, RA Capital Management has been hit hard this year. The 1.5 billion in assets under management has turned into a portfolio value just shy of one billion bucks. Sure some hot new hedge fund is bound to take it’s place atop this list, just like some hot new it girl is bound to grace the cover of Sports Illustrated next year, good luck speculating who.

Optimistic and eager youngins want a piece of that action (talking about hedge funds fam), and it is hard to blame them. But overconfidence mars them at every step and it trickles down to those who invest in their presumptuous presentations. Nothing highlights pompous behavior more than when we blame others for our mistakes as this tantrum, wonderfully covered by Morgan Housel, recently did. Reading that letter you wouldn't be wrong to confuse it with this one, but I digress. Instead of risk reduction we know that overconfidence can lead to an increasing exposure to risk, also see here.


The leading expert on confidence summarizes it succinctly:

“Hard to be humble when you stunting on a jumbotron”

- Kanye West “Devil In A New Dress”

Even harder I’d imagine when you’re dreaming of jumbotron worthy status.

The title of this post isn’t “Mother’s don’t let your children grow up to manage hedge funds”. More power to you boo if you got your sights set on delivering alpha. But let’s treat sophisticated investment products as just that, sophisticated. As the OG grand-master of errythang rational & the oracle from the movie Up says "only invest in what you know b". It starts by undressing these devilishly wicked funds and asking the tough questions: Correlation or Causation? Alpha or Beta? Icahn or Ackman? Method Man or Raekwon? This ish is far from easy fam, word is bond. 

Never forget the underlying rule in all things finance: “You need to crawl before you ball”- Yeezy in Paris. 

Follow Wesley Vaughan @bragavaughan