Let's All Be Hedge Fund Managers

Facetious my title certainly is. Truth is, however, that with tools that exist today, and in the ever-expanding ETF world, any investor can be their own hedge fund.

[Interesting side note: News out recently has shown that regulation on the hedge fund industry may not be tightening at first thought: See “SEC Hedge Fund Registration Rule Struck Down by Court” from Bloomberg News.]

There have been numerous hedge fund debacles globally, leaving many investors, some of which should have never been in anything close to these instruments, completely devastated. A few serious ones have created big news up here in Canada over the past year. Despite this, hedge funds are proliferating like flowers (I was going to say weeds but it would be unfair to generalize). With recent evidence of no increased regulation on hedge funds, which I broadly define as mutual funds with fewer constraints, should we be getting worried?

Naaahhh, let’s all get out there and make tons of money! Seriously, we’ve all heard stories of ordinary people quitting their day jobs to become day traders back in the last 90’s. A similar migration has occurred in the past five years or so where traditional money managers have moved to start up or join hedge funds.

Why not? More freedom from reduced investment constraints. And the performance fees don’t hurt. Hey, I started in this industry managing directional strategies on equity index futures as well as long-short US equity programs. I’m not going to just flatly trash hedge funds. However, as I’ve said in an earlier entry, there is a clear problem in hedge funds that isn’t actually that new. Similar to many mutual funds that have been and are criticized for charging relatively high fees for what is essentially “closet indexing”, we now see hedge funds also providing more “beta” and less “alpha” than what was promised in their marketing material.

Unlike my previous “weed versus flower” comment earlier, I feel justified to generalize here: far too many mutual funds behave like indices. My fear: the same problem develops in hedge funds.

Many hedge funds state that they aspire to perform well in both good and bad markets. In other words, their performance should be independent to what’s going on in the market. The technical term is being “beta neutral”. The problem is that recent returns have shown that this may not be generally true. In fact, I observe that more and more, hedge funds as a whole have behaved more like “closet indexers”. I don’t think this problem existed prior to around 2003.

Here’s a recent story related to this problem from Sweden, but hedge fund industry watchers are noting this disturbing trend in other areas of the globe. (Note: registration to this site may be required but is worth it if you are interested in getting free news related to the hedge fund industry).

If you don’t want to sign up and are willing to do some research, dig up some of the data available on hedge fund indices and see how they compare to the broad market indices. Long term they differ, but in the past year or so, you see the strong similarities.

Although generally I’ve seen that a lot of broad hedge fund indices (not sub-indices specific to a certain strategy like “long-short equity” or “convertible arbitrage”) have beaten the broad market indices (S&P 500, MSCI World Equity Index, Lehman Aggregate Bond Index) by anywhere from around 1% to 5% in the first five months of 2006, the trend of returns during the strong up movement in the first four months and strong down movement in May provides compelling evidence that hedge funds are following the indices.

I can only surmise that after roughly three years of poor returns, in what has basically been a straight line up in the equity markets, hedge funds have had no choice but to expose themselves to beta while alpha has been (perhaps temporarily due to low VIX or countless other reasons) hard to find. I hope this trend does not continue. Perhaps we will enter a new market environment that is more akin to earlier periods when hedge fund strategies were more viable. As with mutual funds, perhaps there are also simply too many hedge funds. The market (investors) will have to let their money do the walking. With limited alpha, many hedge funds will simply have to die.

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Let me now shift gears and bring us back to the ETF world of today, and what is clearly a significantly different place than where we were just one year ago. We now have many more ways to play the domestic and international equity markets through the recent explosion in non-market cap weighted ETFs (quite a lot written about this in the past few weeks!). In a previous entry, I’ve stated how I think these are not that innovative since the research behind them is quite similar to what Dimensional Fund Advisors have spoken about for decades.

What I find more significant and interesting is the introduction of the new inverse ETFs from ProShares (PSQ, SH, DOG, MYY) … for those of you who know ProFunds, Rydex and the like, these are the ultimate “Futures for Dummies” tool. With these new ETFs, and I can only expect that Rydex will be following up with their own version, the ordinary investor can treat a part of their portfolio in a “hedge fund” like manner. Hey, it’s just leverage. And shorting. Or a combination of both. Hey, should we be getting worried?

Well no. Earlier I stated my worries for a hedge fund industry that has had numerous blow-ups and has too many participants striving to find this thing called alpha. The problem, just like when we bash mutual funds for underperforming some benchmark, is the effect of management fees (along with other costs within a fund like legal, audit, custody and other administrative expenses) on returns. For the do-it-yourself investor, these do not apply. So why can’t the DIY investor have the same tools as the pros? I can’t really think of a good reason. Institutions for decades have had the ability to program trade so that they could adjust a portfolio with just a few keystrokes. We don’t really think of it now, but selling QQQ and buying SPY basically does the same. So what should we expect now?

I think that investors should be able to play the emerging markets, commodities and other asset classes both ways (long/short). There’s nothing stopping them now from shorting EEM or DBC. But for the many investors who do not feel comfortable with the concept of a margin (leveraged) account, this is a good first step. I also wonder if particular investors, including certain institutions with constraints that do not allow them to hold short positions or use derivatives, will see this as an opportunity to make tactical decisions within their portfolio.

Bottom line: Through ETFs, investors have many means to have various broad market exposures. With short (and levered) ETFs, they can also allow certain parts of their portfolio to become “hedge fund-like”. But perhaps it doesn’t have to go to that extreme.

As Roger Nasbaum has recently suggested when discussing these ETFs, perhaps only as a short-term play and with relatively small proportional holdings within the total portfolio, these tools are enough of a hedging tool to add to the overall strategy menu. I would only add that for most investors, the use of this kind of tactical defensive strategy does not have to be used often: major market downturns should be the focus, not the common oscillations that are a common component of short-term market action.

Against what Wall Street, and in particular the self-direct brokerages will tell you, trading frequency is inversely proportional to a portfolio’s overall performance. I just don’t want to have a repeat of seven or eight years ago except it’s now: “Yeah, I’ve dumped that dead-end job. I’m now running my own money as a hedge fund.” Please.