I love meeting with clients. Sharing insights and engaging in lively dialogue about their fears, concerns, wants and needs, our ideas and strategies, and the ever-evolving capital markets… what’s not to love? Well, maybe one thing. Downtime in reception areas, which inevitably leads to perusing the client’s selection of industry publications and coffee table books. Over the years and lobbies, I have only found one truly worthwhile lobby book: Poor Charlie’s Almanack: The Wit and Wisdom of Charles T. Munger. Charlie, of course, is Warren Buffet’s longtime right-hand man, business partner, and friend since 1959, and the book offers worldly insights on Charlie’s thoughts about decision-making, investing, and life.
When describing some of the “idiocy of investment management,” Charlie tells a story of an encounter with a fishing tackle salesman who was selling lures that bore little resemblance to fish. “I asked him, ‘My God, they’re purple and green. Do fish really take these lures?’ And he said, ‘Mister, I don’t sell to fish.’” (Munger, 2008). The analogy is a good one. Investors often buy what they think is exciting, sophisticated, and complex with the embedded assumption that all of these attributes will lead to greater returns. We see this today where we witness the continued explosive growth of hedge funds. But, a careful examination of the data reveals that these fancy lures fail to hook as much in excess, after-fee returns as more time tested strategies.
The Expectations Gap
Research Affiliates is on record stating that future capital market returns will be lower, indeed much lower, than the experience of past decades. Lower yields essentially assure this outcome (even as falling yields create outsized gains, raising client expectations!).
In mainstream stocks and bonds, we witness paltry yields and still high valuations by historical standards—hardly the sorts of levels indicative of a new secular bull. As of the end of March 2013, the price/earnings ratio (as measured by trailing 10-year earnings) is 23 for the S&P 500 Index, approximately 37% above the long-term average.1 The yield on core bonds, as measured by the BarCap Aggregate Index, stands at 1.86% as of March 31, 2013.
By combining stock and bond return estimates in a typical balanced construct of 60% stocks and 40% bonds, we arrive at a sobering long-term return estimate of approximately 4%. A 4% return isn’t terrible, especially when banks pay us about zero. It only seems dreadful when we are planning, based upon an historical accident of outsized returns experienced in our lifetime, for much more.
This leaves virtually all balanced portfolios between a rock and a hard place. Accept lower prospective returns or go for broke in a quixotic quest to make 8%. Today, we see too many investors trying to go for the latter. But, singed by two nasty bear markets in a decade and rolling bursts of volatility, they are leery of risk, which makes them prey to anyone willing to tell them what they want to hear. Who among us doesn’t want less risk and more reward?
Enter the hedge fund and its implicit promise of absolute returns, largely independent of market direction. Some investors, notably mega endowments, have reaped both outsized returns and substantial diversification from these investments. Alas, while there are terrific hedge funds out there, most observers would agree that not everyone can hire them. As our own Chris Brightman (formerly of the endowment world) likes to say, “The hedge funds that produce these kinds of results will never manage your money.”
Nevertheless, hedge funds’ popularity and increasing adoption can’t be disputed. But on average, do they hedge (reduce risk) and do they fund (i.e., deliver returns to serve our retirements and other liabilities)? To test this notion, we add various levels of the HFRI Hedge Fund of Funds Composite to a simple 60/40 blend of the S&P 500 and BarCap Aggregate Bond Index over the past five years as seen in Figure 1. Why the last five years? Because it represents what many newer investors, those rushing to follow the endowment model in the middle part of the last decade, have actually achieved. Between 2002 and mid-2007, total hedge fund assets went from $626 billion to $1.7 trillion, a nearly three-fold increase. Today the hedge fund industry manages $2.25 trillion of capital according to HFRI.2 Plus, the last five years have seen a variety of environments to qualify as a market cycle.3