Opinion

Felix Salmon

Why the mass affluent should avoid hedge funds

By Felix Salmon
September 16, 2011

A fund-of-funds manager emails to take exception to my post on Anthony Scaramucci. “Your piece definitely has a negative bias,” he writes (guilty!), before adding:

I also take exception with your point that the mass affluent shouldn’t be able to invest in hedge funds. why not? 90% of active mutual fund managers underperform each year. these funds are 100% long in all market scenarios. Why is that good for the mass affluent—or anyone else for that matter?

I’m certainly not saying hedge funds are a panacea for underperformance. But there is no shortage of excellent hedge funds to choose from and I see that many now come in registered vehicles, offer daily NAVs and daily liquidity just like a mutual fund. if one can avoid the gambler, speculators and pretenders, I would think a hedge fund option for the mass affluent actually makes a lot of sense.

I think this is simply false. Let’s grant, for the sake of argument, that “there is no shortage of excellent hedge funds to choose from”. It’s a long, long way from there to saying that there’s any overlap at all between the set of excellent hedge funds, on the one hand, and the set of funds which come in registered vehicles and offer daily NAVs and daily liquidity, on the other. In fact, I feel quite comfortable in saying that no excellent hedge fund offers daily liquidity. If you can name one, do let me know. But so far it seems to me that funds offering daily liquidity are generally small, untested, and dangerous.

Even if my correspondent is right, then, that a hedge fund option for the mass affluent makes sense in theory, he still runs into the problem that it’s actually impossible to “avoid the gambler, speculators and pretenders”. Investing in hedge funds is really difficult — very few people are good at it, and doing due diligence on hedge funds is an extremely expensive and time-consuming process. It’s something that a mass-affluent investor is utterly unqualified to even attempt.

In general, fund of funds are sold, not bought. Insofar as they’re available to the mass affluent (however that’s defined), they’re generally made available by brokers working for the likes of Merrill Lynch or Morgan Stanley. Those brokers phone up their millionaire clients, and persuade them to put some portion of their money into a fund-of-funds of some description. Sometimes, as in the case of Fairfield Greenwich and other Madoff feeder funds, the fund-of-funds should properly just be called a fund-of-fund.

And of course it goes without saying — because it’s almost never openly discussed — that the reason brokers are so keen to pitch these products is that they get whopping great commissions for doing so. As a result, the funds that mass-affluent investors buy into tend to be the ones which are most generous to brokers, rather than the ones which might objectively be the best.

On top of that, the brokers themselves, even if they’re not driven by commissions, have no real ability to do due diligence on the funds or fund-of-funds that they’re recommending. Indeed, I’m not sure that anybody has worked out a way of doing thorough due diligence on a fund-of-funds.

More generally, there has been no remotely reliable study, as far as I know, of the relative merits of mutual funds as opposed to hedge funds accessible to retail investors, when it comes to returns either risk-adjusted or nominal. Quantifying the ability of mutual funds to beat the market is hard enough, given survivorship bias and other problems in measuring the universe. For hedge funds, it’s much, much harder, since there’s no public listing of the total returns of these things, especially net of fees, and it’s pretty much impossible to find third-party verification of hedge-fund returns.

Yes, mutual funds are 100% long in all scenarios. The alternative is that they become market timers, which is very hard and prone to going disastrously wrong. But if you are going to become a market timer, it’s far from clear that the best way of doing that is to invest in hedge funds, rather than just investing more or less money in stock-market index funds, depending on whether you think they’re overvalued or not. Hedge funds might be smarter, but they’re also more expensive. If you don’t have the resources to do a deep dive into the fund in question, working out whether it’s a good bet compared to its peers, then you’re better off steering clear of the asset class altogether.

Comments
11 comments so far | RSS Comments RSS

Ironically, the fund of fund manager’s email to you he brags about the “daily NAV and daily liquidity” available to many Hedge fund investors. Ironically, unless you are willing to invest in illiquid investments and decline to pay for the “liquidity premium”, I don’t see any way that these funds over-perform broader passive index funds, especially after taking into account admin costs.
Hedge Funds may have more tools at their disposal than long-only mutual funds, but they are also far more expensive. So unless you enjoy paying the 2+20 fees, I don’t see this any way Hedgies should be broadly appealing to the mass-affluent

Posted by EconMaverick | Report as abusive
 

This is a very well-written and correct description of why people should avoid investing in ***funds of funds*** or rely solely upon the recommendation of paid advisors, both situations where due diligence on the underlying investments is difficult or unattempted.

You’ve described in the past why you prefer indexing to active strategies, but that’s not appropriate for everyone (nor could it be…there’d be no market if everyone indexed). I don’t see any reason why the mass affluent shouldn’t be able to find active managers with strategies that suit their risk tolerance (which may include hedge funds in addition to long-only managers). Yes, it’s hard to do diligence on those managers. But why should it be impossible?

Posted by loudnotes | Report as abusive
 

There are a number of mutual funds that essentially are hedge funds or FOFs. Check out AQR Managed Futures or Eaton Vance Global Macro Absolute Return Advantage. Both are long-short and can have notional exposure well over 200% of assets though derivatives. Or Absolute Strategies, Absolute Opportunities or Hatteras Alpha Hedged. These are both FOFs – yes, investing directly in hedge funds, but they are 40 act mutual funds with a daily NAV and liquidity. 2 out of 3 have 5+ year track records.

Mutual Funds can do a lot – up to 15% illiquid assets, quarterly lockups – a number of bank loan funds operate in this manner. So it’s very feasible that someone could own a crappy mutual fund, that essentially is a hedge fund.

If an investor has an understanding of what they own, what it costs, how their broker gets paid, what the expected risk-return is, when it will do well, when it will not, what the downside/upside is, and how and when they can get out, why shouldn’t they own a hedge fund or FOF? Obviously that’s a long list, but I would say many investors don’t have a clue what influences something as simple as the muni bonds they own or the fact that they are highly unlikely to sell the bonds at the price they are marked at.

The big brokerage firms have large staffs that vet HFs and FOFs – CFAs, CPAs, former FoF managers, former securities analysts etc. They go through the books, do extensive background checks, talk to the fund staffs for months before the products are available to clients. Are they good at picking outperformers? Most likely not. But who is any good at picking mutual fund outperformers?

Posted by TO_13 | Report as abusive
 

Excellent article Felix. I love the term ‘mass affluent’ but remember that an atom has mass but it isn’t that big.

It seems to me that, in most cases that I’ve seen, Hedge Funds are sold as part of a package of mutual funds and hedge funds, stocks and bonds in a portfolio that follows a strategy set up by the bank whose products are predominantly picked for reasons of commissions if nothing else. Few ordinary mortals, rich or otherwise, affluent or poor, ever know what is in these products. Maybe that’s a fault of human nature, but they put their trust in the bank which holds most of their assets. Otherwise they wouldn’t leave any money at all with that bank.

Maybe it’s different in the US, I can’t say, but whenever I’ve compared returns of the average Fund of Hedge Funds Fund with the average Mutual Fund, the performance has been broadly similar, the Hedgies have fallen and risen in the same way as the Mutuals, and apart from the huge charges (2+20, as has been said) are the only difference. Given that they don’t make more money than Funds, why on earth should an advisor put his clients into such an intransparent vehicle with so little investor protection behind it?

If you look at the Hedge Funds individually, which ones do you choose? There are no ‘managed’ funds, they all aim at incredibly small niches that may be good for three months here and four months there, but cannot be left unattended for a year or two as can a Mutual Fund. Such micro-strategies need to be grouped or regularly switched into or out of to reach optimum performance, and then you get into market timing which never favours the investor.

Posted by FifthDecade | Report as abusive
 

There is a lot I’d take exception with in this post but, it being Friday and all, I feel like being balanced.

I agree: Brokers at private banks largely sell what they get paid to sell. Next thing you’ll tell me they get free dinners and rounds of golf too! Yes, the commissions on FOFs in particular on those platforms are staggering. I would note, though Skybridge doesn’t get a meaningful percentage of their assets from that channel, just saying.

I disagree: That not being 100% long makes you a market timer. the 150/50 or 130/30 model has a massive amount of the quant-wonk research you seem to want to use to justify an inherently qualitative process (investment). Being Long/Short isn’t, by definition, market timing (as your statement suggests). Many FOFs and HFs are very good at what they do (net net of all fees and taxes).

The real reason they aren’t available to the mass affluent is that the LP structure makes the mass affluent an unattractive option for the funds, not the other way around. UCITS aside. We’re almost out of investor slots, why would we ever take $20,000 from some journalists’ 401K and waste one of those precious investor slots.

Posted by BRM_3 | Report as abusive
 

Nobody should invest in anything they do not understand, anything which they pay significant fees for, or anything they cannot get their money out of in 24 hours. Period.

If you want to hire someone else to actively manage your money for you, do it through closed-end funds, which not only have lower fees than mutual funds (because they are not marketed), often trade at a discount to NAV, and are not forced to sell low and buy high by the inflows outflows of investors cash (since they have a fixed number of shares and trade like stocks).

Posted by mfw13 | Report as abusive
 

“If an investor has an UNDERSTANDING OF WHAT THEY OWN, what it costs, how their broker gets paid, what the expected risk-return is, when it will do well, when it will not, what the downside/upside is, and how and when they can get out, why shouldn’t they own a hedge fund or FOF?”

How can an investor possibly understand what they own when investing in a fund-of-funds? At least when investing in an individual hedge fund, you have a clearly identifiable manager and investment philosophy. A FOF is more a bet on the concept.

“Nobody should invest in anything they do not understand, anything which they pay significant fees for, or ANYTHING THEY CANNOT GET THEIR MONEY OUT OF IN 24 HOURS. Period.”

Unfortunately, including that last line pretty much eliminates any REAL investing behavior. Earlier this year, my brother invested $20k cash in an asset that he hopes to grow into a $20k/year profit stream. It can’t be flipped overnight, however.

If hedge funds have any advantage at all over individual investors, it is their ability to make substantial illiquid investments in smaller unappreciated businesses. That illiquidity ought to be acknowledged — but it is a strength of the model, not merely a weakness.

“But if you are going to become a market timer, it’s far from clear that the best way of doing that is to invest in hedge funds, rather than just investing more or less money in stock-market index funds, depending on whether you think they’re overvalued or not.”

Market timing is a fool’s game. Even if you can accurately spot irrational markets, the market can remain irrational for far longer than you can remain on the sidelines.

A better approach, at least for me, is to adjust positioning WITHIN the markets. Compare valuations between the techs and the banks, between consumer products companies and pharma, between competitors operating similar businesses in similar markets. You’ll frequently find gaps of 15% in relative valuation.

Using this approach, you’ll tend to track the overall market even when it REMAINS irrational. And as long as you call the relative valuation accurately, the gap will eventually close. (Sometimes months, sometimes years.) Suppose it is a version of long-short trading, but without the volatility of the more aggressive strategy.

Posted by TFF | Report as abusive
 

TFF, again I maintain that anyone who puts their money in an investment they don’t understand in a hope that somehow it will “outperform” deserves to get taken to the cleaners.

Also the chances a fund of funds net of fees is going to give a good risk-adjusted return for the “mass affluent” is zero. Mass affluent is where the dross gets dumped after every single last penny of excess profit has been rinsed out.

Posted by Danny_Black | Report as abusive
 

TFF…pretty much any stock, ETF, closed-end fund, and mutual fund can be sold with the click of a mouse, so I’m not sure what you mean when you state that that eliminates “..any real investing behavior…”

Posted by mfw13 | Report as abusive
 

mfw13, I gave you an example of a real business investing in real property that will produce real income. My brother didn’t buy a stock, ETF, or mutual fund. He was engaged in real, direct investing.

Now I’m sure you’ll qualify your statement to insist that you didn’t INTEND your rule to apply to direct investment in businesses and assets. Yet there is a broad grey area between direct investment and purchasing existing securities in large publicly traded companies. Some hedge funds find profit in that semi-liquid grey area, and I don’t see how you’ve made a case for that being poor investing behavior.

Posted by TFF | Report as abusive
 

thanks for this very good article Felix.

You are just expressing one key issue with HF: who are they? how do you select HF? Are the big asset managers offering access to HF or packaging active funds in mutual funds (with higher commissions!) qualified as HF? Are HF only independent firms? Some are in the FT listed everyday with fund pricing.

I agree that HF are not for mass affluent. And not only because of their illiquidity risks; because of non transparent business models, because of poor branding and business issues (organization, controls etc..). If you invest with an independent firm, you are potentially exposed to business risk.

Some argue that HF should be included in pension plans, it could make senses because in general they do offer better risk/return profiles. However, which HF firms can qualify? Very difficult case.

In my opinion, as long as HF are not totally transparent on their activities, as long as they do not communicate properly as asset managers do, they restrict themselves to the ones that understand what they do and how they do it.They are more in a logic pf production, not distribution.

Finally, they are good HF managers offering daily liquidity! I can send you the list. If they trade liquid assets such as Futures, stocks traded in listed markets, liquidity is not an issue, market pricing can become one under market turmoils.

Posted by asterias | Report as abusive
 

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