Another woeful year and yet another nail in the coffin for hedge funds & their supposed “alpha”

Simple buy and hold merchants are no doubt happy with what US markets delivered in 2012. The main market gauge, the S&P 500 rose 13.4%, the tech index Nasdaq 100 rose 16.8% and the small cap index Russell 2000 closed out the year up 14.6%. No matter what the flavour you choose, all the main equity indices show gains for 2012 as markets continued to recover from the 2008 financial crisis.

Investors swallowing the myth of hedge fund “alpha” (read “insider trading” and that is being heavily clamped down on in the US with the suited and booted “whizz kids” not relishing the thought of wearing orange jump suits and sharing a 12 x 12 cell with “Bubba” and his pals!!) and paying for looking “professional” fund continue to have another frustrating year in 2012 as hedge funds (and their more staid brethren the “mutual funds”) have massively underperform the market. Again.

According to Bloomberg data, for the first nine months of 2012 (latest qtr figs yet to be produced) 88% of hedge funds underperformed the S&P 500 (and none more than poor old John Paulson!!) and more than 65% of mutual funds followed the same route. The average hedge fund return throughout the period was just shy of 1.3% and which is far, far away from the 13.4% the S&P 500 registered. Adding to the frustration is the fact an investor could mimic the assets of S&P 500 by investing in a ETF which generally charges a commission on initial assets that may be lower than 0.25% while to open a position in a hedge fund, an investor would generally have to pay 2% of the assets and a commission on profits that can be as high as 20%. Now, I personally don’t mind pay 20% but for that they have to outperform the market by a wide margin and protect the downside in shake-outs – this myth was well and truly exploded in the bear market with the hedge fund industry collectively delivering negative returns and so debunking once and for all the myth of capital protection in bear markets.

During 2011 a total of 635 hedge funds ceased to exist and assets were returned to investors as managers find it increasingly difficult to generate the performances they achieved ten or more years ago. The aim of a true hedge fund is largely to neutralise so called “systemic” or market risk and this generate positive returns in up or down markets. There is an argument that it is not appropriate to benchmark against the S&P 500 but rather against proper surrogates with the same risk level, but in a world where risk is effectively being suppressed by the Federal Reserve who have been reducing interest rates and injecting every more cash into the system to inflate equity prices, nobody seems to care about downside risks anymore and thus hedge funds are having an increasinly tough time in the new “centrally (bank) planned world”…

The major underperformance delivered by mutual funds with a long bias is all the more damning and shows that collectively, the fund management industry cannot stock pick for toffee. With regards to the hedge funds, the underperformance has been attributed to many factors here, some related to bad asset allocation calls as with Paulson’s bet on the European downfall that didn’t come about, others attribute their woeful returns to the ever-growing political influence in markets.

Over the last few years, the Western markets have been in a rising trend but punctuated with sharp directional changes – these are hard markets to trade, no doubt about that and it’s hard to know when to rein in leverage – this seems to be a common factor with many funds – outperformance on the up but giving it all back on the down (sound familiar?). With the fiscal cliff debacle and the debt ceiling issue in the US, a seemingly never-ending sovereign debt problem in Europe etc all creating turmoil in markets, spare a thought for your poor impoverished fund manager having to navigate these choppy waters…

But while the hedge industry en bloc continues to drive another nail on the coffin of “2 and 20”, there are a few fund managers who have picked the correct asset class in the current environment and are being remunerated, amongst with their investors, very handsomely. With the FED’s commitment to maintain low borrowing costs and so save US home owners, according to Bloomberg data, the top 4 performing funds have a simple strategy – investing in Mortgage-Backed Securities (MBS) arbitrage. As the table below shows, this seemingly boring area has definitely been the place to be. 2012 was certainly the year for the MBS arbitrage strategy as it trounced other asset classes.

Deepak Narula, fund manager for Metacapital Mortgage Opportunities fund, betting on MBS, is certainly a very happy man with his fund was up almost 38% in the first nine months for the year. Pine River Capital Management was another company playing with MBS securities and achieving top performance. With the FED announcing an hefty unlimited purchase of $40 billion MBS per month, these fund managers certainly got to take home bacon last year.

Conclusion

There are some conclusions we can draw from what is happening in the hedge fund industry. First of all, hedge funds are no longer what they used (or purported) to be. If indeed they ever really were… Many strategies simply do not work under the current landscape with the FED playing the role of “the invisible hand”. In order to achieve the top slot last year, these MBS focused funds had to engage in much more risk than a hedge fund would traditionally bear, and so it is probably a misnomer to call these outperformers “hedge funds”.

For investors looking for true “alpha” then you need to find an increasingly rare fund manager with experience and a record of returns over a market cycle – both up and down, not the hot shot manager in the fashionable investment class who just happens to be in the right place at the right time. It has been shown time and time again that the vast majority of medium term returns come from being in the right asset class. Find a good asset allocator and you have a chance of outperforming. Jump onto the “sexy” bandwagon after a bull run in that class and odds are you are setting up for disappointment.

The sad reality for the vast majority of investors is that they are really better off buying a tracker or ETF instead and avoiding the extra fees for almost guaranteed underperformance.