Before starting this, I want to inform readers that I will delay next Sunday’s write up until Tuesday as I am going to take a little time off to play golf with friends of mine this weekend. It’s time to recharge the batteries a bit.
What I want to do in this post is to simply wrap up the discussion on hedge funds as a means of absolute return investing, which we discussed in Parts 6 and 7. I want to respond to a couple of e-mails regarding the idea that hedge funds have not been good investments over time. In aggregate that might be true, but what good investors have to do is research to find the best investments. Let’s discuss that for a moment.
In addition to the indexes and research I referenced last week, one can find performance ratings in publications like Barron’s and their at least semi-annual list of 100 Top Hedge Funds. Barron’s obtained much of their data from BarclayHedge database. The basic database is free. Summary data and detailed investment information for funds is subscriber-based. Among those funds were those of rather controversial managers like John Paulson of Paulson Credit Opportunities Fund which finished first with a 3-year return (compounded) of 122.92%. The point of this discussion is that one must look at the best performers over at least a three year period (and I think five is actually best) for each strategy one is interested in before one purchases a hedge fund. What one will notice is that even if the performance in one year is subpar, the strategies can be self-compensating as long as the basic strategy is adhered to rigorously. (Read that Barron’s article to see the performances of a fund that had huge successes in 2 of 3 years, which more than compensated for the damages done in 2008.) If one has the funds and can identify the managers that have the best longer-term records in the strategies one prefers, one can find outstanding performance. As with all investments, if one does one’s homework, one can succeed. If one uses a dartboard, particularly in the hedge fund world, one will select a loser in all likelihood. I would imagine the skewness across the universe of hedge funds with a given strategy is quite large in regard to the probability distribution of hedge fund annual returns.
What about the future of hedge funds? Some think that the golden era of these funds are behind us now. Look what happened this week when Stanley Drukenmiller resigned from the management of Duquesne Capital Management Fund. If you read this article (and I hope you do), I think you will agree with me that even more than his mentor George Soros, this guy was and is, in my opinion, a legend among money managers when you realize how broke he was when he started in 1986 and how well he has done on a percentage basis since starting the Duquesne Fund. Why did he quit? His returns began lagging not only his stellar 30% average annualized return since 1986, but lagging the very index averages I have been discussing.
Here is where I may begin at least partially my discussion of why managers quit. Though it is not directly discussed in this article, many believe that the technique of using huge bets on sectors or special situations will work in the current world slow-growth economy. This is particularly true when a fund becomes massive (and, by the way, that goes for mutual funds and NOT just hedge funds). This is a 12 billion dollar fund. Though perhaps not as massive as some index funds out there, it is still the equivalent of trying to steer the U.S.S. Ronald Reagan in a category 5 hurricane. Because sovereign debt issues can create large swings in currency values and commodity prices, holding positions for wide gains is getting tougher and tougher to do each year. In the case of John Paulson, one I think could effectively argue that he used specialized knowledge (inside or otherwise) of a rare opportunity to do the equivalent of Babe Ruth pointing to the area of the outfield to hit is home run and then slamming the walk-off four-bagger. To paraphrase this analogy with my typical redneck grace, “It ain’t likely to happen again soon.”
Already, managers like Bill Gross are writing about the growth constraints of capitalism, and ”the new normal” with low (2 3% annual gains in stocks and low interest rates) for the next few years. The tails of these distributions will be rather fat as well, meaning one will have to have a bit of timing AND asset value estimation to succeed, make longer-term wide range bets impossible. I think, as others have commented over the past week in blogs and media that Drukenmiller realized that his formula for great success has little chance of repeating in his career. Mr. Druckenmiller, is deciding, as many famous successful athletes have done in the past (not including Brett Favre), to leave at the top of his game. It helps to have amassed (and deservedly so) a billion dollar fortune to lean on in retirement, but the situation remains. The conditions for which his success could be repeated are likely over and he is hanging up the spurs while he can. I contend, despite what he has personally said that this same reasoning was behind Peter Lynch’s retirement from the Fidelity Magellan fund. When I get into what works in bull markets, I will dive into this a little deeper. Successful strategies have to change as conditions change. Old strategies are not only bad for annualized returns, but hard to break away from as well.
What does the new normal mean for hedge funds? It’s a little hard to say, but a couple things are certain.
1) If taxes go up, those returns (after fees) in a low return environment are going to get whittled down quickly. If a fund does not keep up with annualized returns, that fund is going to collapse ultimately, as investors (yes, even accredited investors) will chase return and chase failing managers out of the business. That means, of course, that hedge fund failure rates are going to continue.
2) This contention many of you will laugh at, but I quite frankly do not care, because, regardless of political bent, one knows how inefficient government is to conceive logical legislation. Instead,it plugs the leaks and causes the ship to tilt in weird ways, ultimately damaging the ship to the point of sinking. As inflation increases (and with the kind of debt we have, the odds are high at some point on the back end it will), many more people will end up becoming accredited investors, as a million dollars will become less and less valuable over time. Much like the Alternative Minimum Tax, the level of capital required to become an “accredited investor” in the U.S.A. will not be indexed for inflation. That could ultimately mean that an entire new cast of risk-averse investors will get sucked into the “high return” world of hedge funds, be disappointed by returns, and then go running to their Congresspersons and Senators to regulate the daylights out of them. Yes, I think the entire concept of high-risk-high-reward funds will slowly disappear or be driven offshore to nations that will allow such investment to remain unregulated.
I guess my point in discussing the above doomsday scenario is that individual investors, entities, trusts, and corporations are ultimately going to have to take responsibility for their knowledge of investments. That means devising ways of avoiding too much risk. As we have seen, the hedge fund world (as the mutual fund and ETF worlds) has great performance in places, but in aggregate, unspectacular returns. The days of long-duration position holding, despite all the mantra hummers in brokerage firms or fund companies of “buy-and-hold”, are also long gone as international inter-market relationships make volatility ,and not aggregate return, “king”.
At some point, persistent “buy and hold” could return, but it will take a real eye for value and trend in the current environment to find better-than-average returns. Hedge funds could still work for large investors, but the tax collector and the regulators are conspiring to make this choice less and less advantageous over time. One must do one’s homework if one is to succeed at investing. There are no longer easy panaceas upon which to cling. The “new normal” means both paddles are in the water and churning at full speed.
I will get into what small investors may be able to create their own hedge fund in the next post.
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