By Ted Seides, CFA
Just as stock picks sometimes head in the wrong direction upon purchase and call into question whether a thesis is early or wrong, so too has hedge fund underperformance over the last seven years raised the question of whether hedge funds are bent or broken. Standing seven years into a 10-year wager with Warren Buffett, we sure look wrong.
What follows is an assessment of what happened, and an outlook on where to go from here. A number of cyclical headwinds have hindered hedge fund returns, particularly over the last six years. When put under a microscope, hedge funds look a little better than they appear on the surface.
The late Peter Bernstein liked to say that despite what we may think, we don't know what will happen in the future. We believe that those extrapolating from the recent past to call for the demise of the hedge fund industry are probably a bit extreme. Our contention is that the last seven years may prove one of many periods when lean times are followed by fat ones.
Buffett's Big Bet ("The Bet") took the view that high fees would ultimately doom hedge funds to underperform the S&P 500 over long periods of time. As he described it at the Bet's inception:
Costs skyrocket when large annual fees, large performance fees, and active trading costs are all added to the active investor's equation. Funds of hedge funds accentuate this cost problem because their fees are superimposed on the large fees charged by the hedge funds in which the funds of funds are invested.
A number of smart people are involved in running hedge funds. But to a great extent their efforts are self-neutralizing, and their IQ will not overcome the costs they impose on investors. Investors, on average and over time, will do better with a low-cost index fund than with a group of funds of funds.
Buffett's case implies that the market should win by approximately the amount of fees paid to the hedge fund and fund of funds managers. However, after seven years of live action, the lead taken by the S&P 500 is substantially more than the difference in fees would suggest.
"Fund of Funds" is the composite return of the five hedge fund of funds selected by Protégé Partners, LLC ("Protégé") for the Bet. Returns reflect actual results of the fund of funds in the Bet are from 2008-2013 and estimated results for 2014. Management fees are estimated as 1.5% of net assets per annum for hedge funds and 1.0% of net assets per annum for fund of funds. Incentive fees are estimated as 20% of gains per annum for hedge funds and 5% of gains per annum for fund of funds, both subject to a high-water mark.
Just over half (24.4% ÷ 43.9% = 55.6%) of the underperformance by hedge funds can be attributed to fees. A full 19.5% of cumulative underperformance, or approximately 2.6% per annum, must have been caused by something else.
Furthermore, the first year of the Bet, 2008, heavily favored hedge funds, so the "something else" was even more pronounced thereafter. Over the last six years, the S&P 500 returned 159%, in comparison to the 57% return of the fund of funds. Using our estimates, fees subtracted 22% cumulatively from returns over those six years, accounting for only 21% of the performance shortfall in this stretch.
Over the vast majority of the Bet's duration, 79% of the outcome has been determined by something other than fees. So much for the 80/20 rule!
Six Separate Years, One Distinct Environment
The "something else" can be discovered when breaking down the components of a hedge fund's return. Stated simply, the return earned by a hedge fund is a function of the beta embedded in the strategy, the return on cash balances, the alpha from security selection, and the fees and expenses incurred along the way.
We believe the headwinds faced by hedge funds have resulted from a combination of the substantial outperformance of the S&P 500 over global equity markets and the adverse impact of the Fed's Zero Interest Rate Policy (ZIRP) on hedge funds relative to other investment vehicles. Together, these factors wreaked havoc on a bet, the prospects of which we initially felt quite confident about. As we intend to show, the residual performance after adjusting for the impact of this investment environment manifests a return stream that could have been beneficial to a diversified portfolio of risk assets under different circumstances.
Mismatched Market Exposure
We believe the S&P 500 is not an appropriate benchmark for a portfolio of hedge funds. That said, it's hard to fault Warren for choosing the S&P 500 as a proxy. Even if it is not intellectually pristine, the S&P 500 is used extensively by investment organizations, clients, and the press as a generic bogey for almost everything related to the asset management industry. I like to quip that the index is so pervasive that upon receiving a semi-annual report card from my children's school, my son's teacher said, "He is performing nicely in math and reading. You should be proud of his work, but he's still not keeping up with the S&P 500."
Hedge funds generally, and the fund of funds chosen for the Bet specifically, diversify geographically, have a small-cap bias, and take on much less market risk than a fully invested long-only portfolio. As such, the Bet represents an apples-to-oranges comparison when pitting hedge funds against the S&P 500. The S&P 500 was one of the best performing indexes in the world over the last seven years, providing a boost from market exposure relative to more diversified hedge fund portfolios.
Global and Small-Cap Bias
The fund of funds in the Bet has essentially matched the performance of the globally diversified MSCI ACWI Index - what a difference the selection of an index makes! We approximate that the underperformance of global markets relative to the S&P 500 contributed 2.3% annually to the shortfall of hedge funds in the Bet.1 On the other hand, hedge funds benefited by approximately 0.5% annually from their small-cap bias.2 Together, we estimate these risk factors boosted the S&P 500 relative to hedge funds by approximately 1.8% per annum or 13.7% cumulatively.
While we do not know the precise magnitude of the underlying beta in the Bet's fund of funds, we believe the underlying funds averaged 40-60% net long. Assuming these funds carry half the risk of the market (represented by MSCI ACWI and adjusted for a small-cap bias), the reduced market exposure subtracted another 1.8% gross of fees per annum, or 13.3% cumulatively relative to the S&P 500.3
The Impact of the Fed
The lower market exposure and lack of risk-adjustment in the Bet did not concern us at the time of its launch. Back in 2007, we believed the high valuation of the S&P 500 relative to history did not augur well for Buffett's benchmark selection. Putting numbers behind our contention, money manager GMO predicted at the time that the S&P 500 would return −1.1% real (approximately +0.6% nominal) per annum over the subsequent seven years.4 According to their estimates, history would suggest that the 7.3% annual gain of the S&P 500 since stood only a 15% chance of occurring.
Why did this outlier occur? Most commentators would point to the impact of central bank intervention on the US equity market. The absolute level of interest rates has a direct effect on hedge fund returns. In taking rates from a market-driven level to zero through quantitative easing (QE), we believe the Fed had a dramatic impact on lowering hedge fund returns over the last six years.
Level of Interest Rates
The investment of cash balances is a source of hedge fund returns, but an inconsequential one to the return of the S&P 500. In the ZIRP environment since 2009, hedge funds have earned 0% on their cash. Depending on the particular strategy, a hedge fund might hold anywhere from 0-90% of its net assets in cash.5 Assuming cash balances average 20%, for the long-short equity strategies in the bet, and short-term interest rates stood at an historical average of 2.8%, a hedge fund's return would have been 0.6% per annum (4.3% cumulatively) higher than it has been over the last seven years.6
Cost of Shorting Stock
Over this period, we believe the cost for hedge fund managers to borrow stock rose significantly due primarily to low interest rates and secondarily to increased transparency and more competition in the stock loan market. When a manager shorts a stock, the security is borrowed from the beneficial owner, such as an index fund, through a middleman, a Wall Street bank's prime brokerage division. The beneficial owner, in turn, receives cash collateral for the stock, pays interest to the borrower on the cash, and reinvests the proceeds at a higher rate to earn a spread.
Before 2009 beneficial owners generated most of their security lending income from the reinvestment of cash above a risk-free rate and a smaller component from the difference between the risk-free rate and the borrow rate paid to the lender. However, after taking a few lumps while chasing yield in 2008, lenders became more conservative in their reinvesting. As a result, we've found that beneficial owners have charged more (paid less in interest) to lend stock for desired shorts to fuel profits in their security lending effort.7
We believe that transparency in the stock loan market has structurally benefited lenders at the expense of middlemen and borrowers. New technology brought price discovery to the security lending market and attuned lenders to the market lending rate for each stock in their portfolio. When markets were opaque, middlemen and borrowers had asymmetric information about prices and took advantage of less-informed lenders. Today the playing field has leveled for good.
Lastly, the growth of the hedge fund industry has created more competition for desirable stock to short. With more demand, the market rate charged to hedge funds to borrow stock has risen. We estimate that the costs of stock borrowing are 5% per annum higher today than before 2009, the preponderance of this increase is attributable to the lower level of short-term interest rates.8 For a hedge fund with 40% short exposure, this cost would have detracted from returns by 2% per year or 14.9% cumulatively.
Sum of the Parts
Putting together this set of hedge fund return drivers reveals a surprising set of results. After adjusting for the market environment, hedge funds had a positive residual return amounting to slightly more than the amount of fees they received. With all the hullaballoo created by lovers and haters of the investment vehicle, we appear to have a tie.
Hedge Fund Expected versus Actual Performance
Source: Protégé Partners.
The KISS Principal Gone Awry
Public scrutiny of hedge funds tends to focus on the underperformance of traditional asset classes, which was embedded in the Bet. As the argument goes, surely all of these sophisticated alternative strategies have no use when we could have just invested in plain old stocks and bonds and performed better.
Making an accurate prediction is hard, especially about the future. As it turns out, alongside the Bet we created an unintended experiment that tests this theory and calls into question the logic of those who claim today that indexing in stocks and bonds was obviously the way to go seven years ago.
At the launch of the Bet, we split and pre-funded the proceeds that would eventually go to the victor's charity of choice. We decided at the time that having more than $1 million in 10 years would be wonderful for the charity, but having less would be unpalatable. As a result, we placed the present value of $1 million in a zero-coupon bond with the intention of letting it sit and mature 10 years hence.
As revealed on the Long Bets Foundation website, commentators on the wager were universally appalled at this decision. Those weighing in on the choice to buy a zero-coupon bond at the low yield of 4.5% went as far as to claim that the only loser in the Bet would be the charity that receives the funds at the end, proclaiming, "Can't [this] money go to the Girls Inc. of Omaha now to get better value on [the dollars?]"
As it played out, the zero-coupon bond was one of the best performing investment vehicles in the world during the financial crisis. By the end of 2012, the Bet proceeds had risen over 50%, from $640,000 to approximately $950,000. With the prospect of making only 5% cumulatively for the next five years, we switched the collateral into shares in Berkshire Hathaway stock.9 At the end of December 2014, those proceeds had grown to $1.68 million. The 14.8% annual performance of the Bet collateral has dramatically surpassed the S&P 500, hedge funds, and almost anything else over the period. As the cliché goes, hindsight is 20/20!
The Next Seven Years
One conclusion to draw from this analysis is that hedge funds may have been no better or worse than traditional strategies per se, offering instead a different return stream and set of risk factors that can be beneficial in a diversified portfolio of assets in the right environment. Proper consideration of an allocation to hedge funds going forward should consider the pricing and outlook for these particular risk factors relative to those embedded in traditional asset classes.
As a starting point, our outlook for traditional stocks and bonds is far from rosy. Bonds generated a 10.9% annual return over the last six years, leaving the 10-year Treasury below 2.0% today.10 It's hard to imagine a repeat of that performance over the next stretch.
Stocks may not fare much better. After returning 17.2% per annum over the last six years and trouncing active managers across the board, the S&P 500 and its rapid rise should give investors pause. Jim Grant recently took the move towards indexation to task, stating "passive equity investing is a good idea. It is such a very good idea, in fact, that it has become a fad . . . Today we have a Nifty 500."11 Grant further quoted an active manager, whose words about the cyclicality of passive and active management resonate strongly:
Long bull markets tilt the investment debate in favor of the autopilot approach . . . it's at that moment that everybody says, "Why do I need a manager?" . . . If you go back and look at 2000 and 2007, there were strong calls for indexing, and the data looked very pro-indexing at those moments . . . And everybody completely forgot about that when active managers beat the market on the way down.
As far as hedge funds are concerned, we think structural characteristics are moving in favor of investors. First, fees are coming down. In response to a period of challenging returns, the industry is in the midst of a wave of innovation geared towards offering the attributes of hedge fund allocations at a lower cost. Second, as the US economy appears on stronger footing and QE comes to an end, interest rates may rise in the ensuing years. In a "normal" environment, hedge fund returns will increase due to higher interest rates on cash balances and short rebate proceeds. Third, although global diversification has hindered returns over the last seven years, the same outcome may not occur in the next seven.
In summary, the upcoming environment will likely be more conducive to hedge fund success than it has been - a point echoed elegantly by Ben Inker of GMO:
If we are in an environment today where we aren't sure whether stocks are very overvalued or whether they have been repriced to give a lower, but still fair, return, taking equity risk in a fashion that has less duration looks like a pretty good idea . . . The strategies that most fit the bill are the very "hedge fund-y" strategies that have so disappointed investors in recent years . . . if you can find a way to do it more cheaply (or you can actually find some managers talented enough to pay for their fees), we believe now is a pretty good time to be on the look-out for shorter-duration ways to take standard risks.
These seven lean years for hedge funds may go down in the annals of market history as a period driven singularly by central bank stimulus. Using that lens, it becomes less clear that the Bet, if lost, proves that hedge funds are not worth an investment across a cycle.
If the Bet continues on its current course, there's always the next 10 years. We happen to know firsthand that Warren couldn't be more excited to watch that period unfold.
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1. Geographic headwind calculation: S&P 500 return (+7.3%) minus the MSCI ACWI return (+2.7%) = 4.6%, multiplied by the 50% net equity exposure in hedge fund portfolios = 2.3%.
2. Small cap tailwind calculation: S&P 500 return (+7.3%) minus the Russell 2000 (+8.2%) = −0.9%, multiplied by 50% net exposure = −0.45%.
3. Market exposure calculation: MSCI ACWI return (+2.7%) * 50% net exposure = 1.35%.
4. GMO Seven Year Forecast (January 2008).
5. If an average hedge fund runs 80% long/40% short, it will hold uninvested cash of 20% (100 − 80%). Additionally, it will hold 40% of NAV in cash from short rebates, the impact of which is omitted in this calculation and later incorporated in the Stock Loan section. Strategies like global macro and commodity trading advisors have minimal need to post collateral and generally hold close to 100% of NAV in cash.
6. The average 3-month Treasury bill yield 1994-2014 was 2.8%. Source: Bloomberg. Annual returns calculated are compounded in estimating the cumulative impact for the seven year period.
7. Most of the money that beneficial owners earn in stock loan emanates from "special" issues, typically highly shorted stocks in high demand. In a higher-rate environment, lenders can earn returns on "general collateral" as well, but with short-term interest rates at 0%, lenders cannot make money on general collateral.
8. Hedge funds typically pay a net rate to prime brokers. The net rate is the difference between the interest received on their cash collateral and the borrowing cost for the stock. Before 2008, an average hedge fund paid a net annual rate of −3% (paid to play) and today a typical hedge fund pays a net annual rate of +2% (pays to play) to execute the same trades. Data received from the underlying data of two large hedge funds and confirmed in conversations with Goldman Sachs, Morgan Stanley and BAML Prime Brokerage groups.
9. Actually, our intent was to make a bet within the Bet and split the investment of collateral half in BRK stock and half in our flagship Protégé Partners, LP fund. Unfortunately, the Long Bets Foundation was not a Qualified Purchaser and could not invest in Protégé Partners, LP, so we elected to put all the proceeds in Berkshire stock.
10. Barclays US Aggregate Index. Source: Bloomberg.
11. Grant's Interest Rate Observer, 14 November 2014, page 1-2.
Disclaimer: All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author's employer.