On Friday the S&P 500 dropped 1.25% and the NASDAQ fell 2.6%, driven by a sell-off in momentum names such as biotechs, FB, TWTR, AMZN, TSLA, etc. There was forced selling as leveraged hedge funds and other speculators liquidated positions. One prop trader told the Wall Street Journal, “A lot of people had been performance chasing in these momentum names. Now they are panicking.” A popular Biotech ETF, he noted, ballooned by $526 million in the first two months of 2014 but has since seen $280 million withdrawn.
“Playing” momentum names—trying to get in and out before the crowd—exemplifies the Greater Fool Theory. TSLA may be overpriced, but it is going up and should become more overpriced. It typifies what many—not all—hedge funds do for a living. They trade short term, trying to exploit market trends and inefficiencies. One reason for their short time horizon: they are paid by the year and lose assets if they fall behind in the quarterly performance derby.
Vanishing Inefficiencies
Here’s the problem. These days, there are very few inefficiencies to exploit and hedge funds have a great deal of money to put to work, trying to exploit these vanishing inefficiencies. Today copious corporate information is instantly available to virtually all investors. FactSet and Bloomberg can tell you nearly anything you want to know about a company; even Yahoo Finance has copious information. Conference calls are available to everyone. Company presentations are on the web before the CEO says a word to the investors and analysts at the Pierre Hotel. One solution to hedge funds’ efficient-market problem is to use illegal inside information, but that has turned out poorly for several funds.
Whether it is used to play momentum names or to exploit non-existent inefficiencies in the stock market, short-term trading is not likely to beat the broad indexes, especially on an after-tax basis. Trading costs are high, and the gains are short-term and taxed as ordinary income. Another hedge fund strategy—trading macro trends—is no more promising. Macro trends are extremely difficult to forecast, and even if you get the economic trend right you may get the market reaction to it wrong. The European economy is still a mess; who could have predicted the Euro would stay as strong as it has? The Fed was unable to forecast the last three recessions, as we know from the Fed minutes.
Then there are the fees. Let’s say Sexy Hedgie has great performance, managing to beat the S&P 500 by 300 bps per year, with annual returns of 13% vs. 10% for the index. It charges 2% of assets and 15% of profits. On average that is 2% + (0.15 x 13%) or 3.95%, which means it underperforms an index fund. And small investors may pay a second layer of fees, to their bank or broker.
Bottom line: Over the long run, most hedge funds will not deliver attractive after-tax returns. Yes, there are exceptions. There are super-traders such as George Soros and Steve Cohen. There are exceptionally talented investors such as the folks at Omega, who ran Goldman’s equity strategy product for a couple of decades. Some other specialized funds may figure out a way to beat the market. But they are exceptions. Which means, quite simply, that hedge funds are not an attractive “asset class.” The average schmuck who walks in to J.P. Morgan with $30 million, and puts $10 million in a few hedge funds, is not likely to do very well. What should she do instead? Assuming the broad stock market is not wildly over-valued, a la 1999, I think she should buy the stocks of high quality companies, mostly U.S. names but with a few world-class foreign companies. After fees and taxes, she will do much better than in hedge funds.
Learn from the Biggs, Mother and Son
A real world example is to be found in the late Barton Biggs’ fun book Hedgehogging, which I recommend. As I described in July 2012, Biggs’ mother did very very well over the years by simply owning a basket of blue chip growth stocks selected by her husband (who was a professional investor) and her sons. Biggs estimates that her real purchasing power rose 12% annually for about three decades.
Contrast that performance with that of her hot shot Wall Streeter son. After he left Morgan Stanley in 2002 Biggs could not bear the thought of hanging around Greenwich and Palm Beach all week long, so he and two friends set up a hedge fund, Traxis Partners. In 2004 they fell upon a great macro insight, which they researched to death and concluded would be a big money maker. They decided to sell short oil. They reasoned that oil prices were at an all-time high, global output was increasing, global demand was slowing, and the U.S. strategic petroleum reserve was full. With oil trading at $40, their elaborate regression models revealed to them that the equilibrium price was $32.50. The trade was a disaster; global demand was much stronger than they figured, and hurricanes in the Gulf of Mexico added to their pain.
My take on Barton Biggs’ oil trade is this: Are you kidding? Why would anyone, especially three guys in a New York office building, bet on the price of oil? (I am reminded of a friend, a successful Street economist, who told me the reason he survived so long in the business was that he never had to forecast oil prices or the dollar.) Why would anyone pay high fees to participate in a bet on the direction of oil prices, especially when they have the option of inexpensively investing in solid growth companies whose dividends will grow nicely over time?
Wealth Managers’ Diversification Trap
Despite their obvious defects, hedge funds continue to be recommended by Wealth Management firms. I am looking at the monthly publication of a well-respected firm, which advises clients with a moderate risk tolerance to invest 10% of their assets in hedge funds and 39% in stocks, with the rest in bonds, commodities, private equity, and real estate. The rationale for this over- diversification is supposedly to limit risk, which is defined as the price volatility of the portfolio. Hedge funds may be a crappy investment compared with stocks, but they won’t go down as much in a bear market, because they are hedged and not too tightly correlated with the equity market.
I don’t buy this logic, because for a wealthy long-term investor like Mrs. Biggs a temporary decline in stock prices—or even one that lasts a few years– does not matter much. They are living off dividends; why should they care if stock prices decline for a few years? Let’s get specific, with United Technologies, a diversified but moderately cyclical Blue Chip. In 2008 the company’s EPS was $4.90, but then the world economy collapsed and EPS fell to $4.12 in 2009 and $4.74 in 2010. The stock price plunged from a 2008 high of $77 to a 2009 low of $37. OMG the stock was cut in half!!! But what happened to the UTX dividend? It rose 26% from $1.35 in 2008 to $1.70 in 2010.
The asset allocators in Wealth Management shops are basically telling clients to diversify out of sound long-term investments (common stocks) into bad one (hedge funds) to avoid declines in the quoted value of their securities, even though they are mostly living off dividends and don’t need to sell at the bottom of the market. This is bad advice, in my opinion.
The Wisdom of Warren
For some reason Buffett groupies tend to overlook one of the major reasons for his success. He does not try to time the market and does not care if one of his long term holdings—WFC, KO, IBM, AXP, or whatever—declines in price during a bear market. He recently directed that a trust for his ex-wife invest 10% of assets in cash and the other 90% in a stock market index fund. If, during a bear market, you need more cash than you get from dividends, you don’t need to sell stock because you can spend the cash.
This makes a lot of sense. Anyone can do it, via mutual funds, by themselves if they want to spend the time, or with the help of an investment advisor who follows a sensible buy-and-hold strategy. The aim is not necessarily to “beat the market” but simply to participate in the long-term success of companies. Transaction costs are low and so are taxes. One key reason this strategy is not followed more is that brokers and investment advisors feel they need to try to beat the market to justify their fees. You need to get over that “performance” mindset.
Copyright Thomas Doerflinger 2014. All Rights Sreserved
