Larry Swedroe, research director for BAM Advisor Services LLC, noted earlier this month that total hedge fund assets under management, or AUM, reached $2.63 trillion. This represents a sizable increase, despite fund performance generously described as lackluster.

The increase in assets under management led to some interesting discussions. Lots of readers had e-mailed me with comments on both alpha — market-beating returns — and fee generation after last week’s column, “The Hedge-Fund Manager Dilemma.”

There is much more nuance to the discussion of hedge funds than is widely understood. Today is a good time to review some of the related issues. Let’s see if we can clarify some misunderstandings:

Some hedge funds generate a lot of alpha: Given the underperformance of the industry, why do so many investors want to participate in hedge funds? The most likely answer is the enormous alpha generated by a handful of star managers.

Last week, this came up in an interview with Jim Chanos of Kynikos Associates (I’ll post a link when its released). Chanos started Kynikos in 1985, when there were only a few hundred hedge funds. The concentration of talent — and alpha generation — became the stuff of legend.

What has changed is the sheer number of funds and the amount of assets they manage. What hasn’t changed is the reality that the best performers capture a disproportionate amount of alpha. The 9,500 new me-too funds are not, according to the most recent data, keeping up with the top hundred funds. Indeed, they are not even keeping up with their benchmarks.

Beating the market is hard: This is obvious, but let’s give some context. Outperformance is a rare and elusive thing. Consistently outperforming in any given five-year period is harder still. Add in the standard 2 & 20 fee structure (a 2 percent management fee along with 20 percent of any gains) , and managers must overcome the enormous drag on returns. Net of fees and costs, we hunt for the rarest of creatures: Funds that earn their keep. It is no wonder that so few funds can meet that challenge. But the lure of outperformance is only one aspect of their appeal.

Cognitive bias and behavioral driven investing: Meir Statman, a professor at Santa Clara University in California, focuses on the cognitive errors that investors make.

In a 2011 interview, Statman noted that people want more than just returns from their investments. They are also looking for the “status and esteem of hedge funds,” he said. It isn’t that different from “the warm glow and virtue of socially responsible funds” that send some investors in that direction. In both instances, performance takes a back seat to the emotional warm fuzzies investors feel. That feeling of belonging to a special club is why some high-net-worth investors are willing to pay up for mediocre performance. It grants them entrée to a sophisticated world they might not otherwise have.

We see this reflected in the mind share hedge funds occupy. Despite managing a relatively small percentage of total investable assets, they capture an unusual amount of media coverage. This may add to the overall mystique.

Selecting emerging managers: Experience has shown us this is an exceedingly difficult task. Beyond our own biases, it simply is a challenge to identify which managers will generate consistently good performance in the future.

The evolution of what happens to successful emerging funds helps to explain why. Some new managers identify unique alpha opportunities. These situations tend to be of modest size, perhaps a few billion dollars worth of market inefficiencies. Often, the emerging funds’ success attracts competitors, and the finite amount of alpha in that area gets fully mined. Very often, we see their success attracting lots of new capital, far in excess of what their niche can support and still generate market-beating returns. Sometimes, their success was simply random, a function of luck, and can’t be repeated or duplicated.

Hence, we are faced with a situation where fees are high, outperformance is rare, and our own biases undercut our ability to select managers.

Note that we haven’t gotten to the issues of hedging, market timing and stock selection. I plan on visiting these topic in a future discussion.

 

Originally published here

Category: Hedge Funds, Investing, Psychology

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

2 Responses to “The Cognitive Side of Hedge Fund Investing”

  1. VennData says:

    Chris Chistie takes a poage out of George W. Bush’s playbook. Bush passed laws in the business miricle state to stop online car sales ad they internet took off. Mission Accomplished, Christie sees the same middlemen as a valuable political allie.

    If you’re a Jesus freak, a single issue “Just lower my taxes” voter or believe Hillary Clinton will send black UN helicopters to your house what do you care about a little extra cost for your car?

    Go GOP.

  2. Livermore Shimervore says:

    Two words. Perceived exclusivity. Works for Porsche when selling to the top 0.01%.
    Turns out it works for HF’s too. People who sell HF’s probably have two categories of leads: dumb rich and ” I better do my homework before this meeting”. I’ve seen this sort of thing, divorced spouse ends up with a bunch of money they have no idea what they’re doing, they ask within their circle of friends what to do, HF sales person shows up before you can say 2 and 20. Wealthy retired physician couple who never really invested with any methodology or research call their buddy from the country club for advice, he refers them to his trusty HF sales person/FA… same outcome. What was wrong with simply investing in a passive index fund? If Joe the Plumber is investing in it then it probably offers no “edge”. Performance on paper says otherwise? Not interested… I want to the red carpet treatment before I write the $500K check.
    Somehow wealthy investors have gotten it into their heads that paying up for average performance (that you could otherwise get on the Costco cheap) puts their capital in some exclusive realm of ‘safe keeping’ mixed with an imagined competitive advantage. Neither are remotely the case, and they end up with below average returns to boot. The smart rich don’t fall for this but they are a minority. HF’s are in the enviable position of having clients who always have more money coming in and don’t make a fuss when things go south. A-B-C always be closing.