5 ms·

Buffett pulls ahead in wager against hedge funds

56 points by mshafrir 14y ago

travisp 14y ago
This shouldn't be too big of a surprise. Most academic research about hedge funds show that the majority of them don't outperform the market. When they do, it appears to be because of greater exposure to particular risk factors rather than manager skill (in investing, greater risk usually means greater potential for reward). When you consider the extra costs of investing in a hedge fund over investing in the market, most hedge fund investors are getting a bad deal -- they are paying more, but getting market returns. One source that looked at 12,980 hedge funds with $1.8 trillion in management: http://faculty.baruch.cuny.edu/tbali/BaliBrownCaglayanJFE2010.pdf http://faculty.baruch.cuny.edu/tbali/BaliBrownCaglayanJFE201...
- wtvanhest 14y ago
  Its possible that I am reading the paper incorrectly, but the conclusion clearly states that manager selection of Beta accounts for a large majority of over or under performance. Nowhere in the paper does it suggest that they do or do not under perform the market. To anyone who is familiar with how money management works, the conclusion in the paper is obvious. Exposure to beta will increase returns in good periods and decrease returns in bad periods. The research looking at "average hedge fund performance" is also misleading because while the analysis is technically correct, the conclusions in those papers are obvious as well. If you hedge out most of the beta, you will get zero return on average. Once you subtract expenses, you will by default perform negatively the market. (in reality, hedge funds do not hedge all beta to zero, they hedge it pretty close to 1 so they track the market, but they probably under track it. This also leads to negative alpha) Where hedge funds play a role in investment management is when individuals can select hedge fund managers they believe will outperform. Professional investors, including fund of funds believe they can do this, and some will do this, some won't and the total will net to less than zero. [[Added in response to additional point below]] The paper cited is using an econometrics model which is using factor analysis to determine where the "biggest" source of performance comes from. Because beta is a factor, it will overshadow alpha automatically if beta is large enough. Alpha between funds will be destroyed in the model so the model will output zero alpha with enough funds. While beta will be persistent since by definition beta is a performance magnifier (for lack of a better term.) In other words, the conclusion in the paper is obvious, and not worthy of discussion. [[Added in response to Jesse]] Yes, if you are aggregate all money invested in hedge funds the average return will be lower than the benchmark that Beta is based off of. ETFs may or may not beat the benchmark depending on the ETF. Some have tracking error which causes them to not beat benchmarks. Also, you may notice that I am not arguing whether the OP is correct, I am generally agreeing with them, but the point is that his assertion is obvious and the cited paper is obvious and provides no real value.
  - travisp 14y ago
    Yes it's beta and yes it's what's expected, but the hedge fund industry has historically claimed that returns are coming from alpha (investor skill) rather than beta (riskiness). There's the claim now that they are picking the right kind of beta to attempt to justify what papers are finding, but the outperformance that is exhibited by some hedge fund managers doesn't usually persist, suggesting that their selection of the particular risks were not a result of their skill. If the returns are actually from "dumb" beta, then the hedge fund fees are not appropriate for what you're getting. You're getting market returns appropriate for the amount of risk that's being taken, rather than outperforming, and then losing most of that to fees. Yes, exposure to beta can be a smart choice, but it can be done without excessive fees. >Where hedge funds play a role in investment management is when individuals can select hedge fund managers they believe will outperform Yes, this is the common refrain in mutual funds too: Buy the top performing managers, not the average fund. But the research shows that hedge funds that outpeform do not persist in outperforming. This suggests that the managers are not being particularly skilled in their selection of risk. Most fund of funds do not perform significantly better either -- there's little evidence that hedge funds are providing investors real value. Hedge funds are a status symbol for the wealthy, not a smart investment.
  - jessaustin 14y ago
    So, the average hedge fund investor will make less money in her hedge funds than she would have made in an ETF? I realize that there are benefits in diversification, but travisp is generally correct.
  - travisp 14y ago
    I can't edit any more, but I thought it might be helpful to others if I add this: I'm not really disagreeing with you either: I agree that the conclusion of the paper is mostly obvious, but it's valuable because it is important to show that beta is overshadowing alpha significantly in hedge funds. I could be wrong, but I would be surprised to see top hedge fund managers claiming that their results come from beta, not alpha. If they did, it would be harder to justify the amount they are paid during periods of good performance. I also do think that some manager skill exists in all areas of the market to a limited and varied extent. But, I suspect that even the hedge fund managers who do "provide alpha" capture most of it with their fees, leaving their clients with market returns or worse.
xntrk 14y ago
Fund of funds get hit pretty hard by fees since each fund takes out there fee and then the fund of funds also takes out it's fee.
- hkmurakami 14y ago
  IIRC the hedge funds take the usual 2 and 20 (though Renaissance Technologies apparently takes 5 and 36 now), then fund of funds takes 1 and 10 on top of that.
deleted 14y ago
[deleted]
outside1234 14y ago
This is not a surprise. Academic research has shown that 80% of funds underperform index funds and do even worse when you factor in costs. Its not sexy to say "take all your retirement money and put it into three funds: international stocks (eg. VEA), domestic stocks (eg. VTI), and domestic bonds (eg. AGG)" and rebalance it once a year to ratio based on your age but the research shows this is the most effective method of investing because it takes the emotion and costs out of it.
- rogerbinns 14y ago
  Vanguard even have target retirement funds (eg Target Retirement 2035 if you expect to retire around 2035). They automatically do the rebalancing for you - all you have to do is contribute while working and that is it! https://personal.vanguard.com/us/funds/vanguard/TargetRetirementList https://personal.vanguard.com/us/funds/vanguard/TargetRetire...
jhowell 14y ago
I think that it comes down to people. To become a C level executive or board member at a S&P company, presumably you've undergone a reasonably level of public scrutiny and shown the courage that Ben Horowitz sometimes references when talking about start up leadership, it takes to make the right and difficult decisions that benefit the business. Not every board member or executive, but the majority. The companies in the fund of funds, presumably don't have the same "blue chip" ratings of the S&P companies and their management may still be undergoing their personal tests of courage. In the end, in the absence of a extremely hot market - which could be a good or bad thing given the experience level of senior leadership, it's probably a better bet to go with the tried and true.
fduran 14y ago
The advice I got regarding stock market from a pro was to invest long term in the 3 indexes: "spiders" (S&P 500), "cubes" (Nasdaq 100) and "diamonds" (Dow Jones Industrial Average), seems solid, outperforming funds and without management fees.
- jvm 14y ago
  DJIA and S&P500 are highly correlated (intentionally so), also I'd recommend diversifying internationally.
- artsrc 14y ago
  If the market is efficient, then the correct investment is market weighted. You are missing the rest of the world and smaller stocks. This implies that you are missing some diversification that would reduce your risk.
  - saryant 14y ago
    That's why I follow the basic three-fund portfolio advocated by contemporaries of John Bogle, founder of Vanguard: VTSMX, total US stock market, VTIAX, total international stock market and VBTLX, total bond market index. Three basic index funds each with very, very low fees compared to actively-managed funds. I'm at 60/30/10% respectively in those funds.
    - Evbn 14y ago
      Or roll them into an auto adjusting target retirement 20XX fund
      - saryant 14y ago
        I would if my 401k included one that wasn't terrible. I do use one of those funds for my Roth IRA though, I just wanted to limit my post to the principle, not the implementation.
- larrydag 14y ago
wpietri 14y ago
Hey! They didn't even mention Long Bets! That's the site that registered the bet and is holding the money. http://longbets.org/ http://longbets.org/ Which I am going to pimp shamelessly here, as I wrote the code for it a decade ago. We have bets that go out many years. There's one that won't be decided until 2150. There's even one about how the universe will end. If you would like to make a similar long-term bet, either use the site or let me know; I'm glad to facilitate. As long as the bet is more than 2 years out and the stakes are more than $200 each, you're golden. We'd love to see the site used more to call out people making bold/crazy predictions. E.g., is somebody saying that NoSQL databases will rule the earth in 10 years? Do you think they're wrong? Tell them to put up or shut up! We'll put you both on record.
- impendia 14y ago
  My favorite: "Large Hadron Collider will destroy Earth."
  - arbuge 14y ago
    I'd be willing to bet everything I have it won't. In fact I'd offer the same for any "XXX will destroy Earth" bet. Let me know if you're interested :-)
- RyanMcGreal 14y ago
  So did Stigler win this one? http://longbets.org/291/ http://longbets.org/291/
  - wpietri 14y ago
    Thanks for the prod. They are now adjudicating all the outstanding best. Stigler did indeed win that one!
- gwern 14y ago
  One problem you guys have is that you aren't updating anything. I've been copying over predictions to predictionbook.com for the last 2 or 3 years now, and a number of predictions have expired - with no official judgment or anything.
rsobers 14y ago
Since hedge funds are subject to bigger swings, I suppose Buffet could be ahead for the next 5 years and then lose out due to a big upswing, no?

56 points by mshafrir 14y ago

This shouldn't be too big of a surprise. Most academic research about hedge funds show that the majority of them don't outperform the market. When they do, it appears to be because of greater exposure to particular risk factors rather than manager skill (in investing, greater risk usually means greater potential for reward). When you consider the extra costs of investing in a hedge fund over investing in the market, most hedge fund investors are getting a bad deal -- they are paying more, but getting market returns. One source that looked at 12,980 hedge funds with $1.8 trillion in management: http://faculty.baruch.cuny.edu/tbali/BaliBrownCaglayanJFE2010.pdf http://faculty.baruch.cuny.edu/tbali/BaliBrownCaglayanJFE201...

wtvanhest 14y ago
Its possible that I am reading the paper incorrectly, but the conclusion clearly states that manager selection of Beta accounts for a large majority of over or under performance. Nowhere in the paper does it suggest that they do or do not under perform the market. To anyone who is familiar with how money management works, the conclusion in the paper is obvious. Exposure to beta will increase returns in good periods and decrease returns in bad periods. The research looking at "average hedge fund performance" is also misleading because while the analysis is technically correct, the conclusions in those papers are obvious as well. If you hedge out most of the beta, you will get zero return on average. Once you subtract expenses, you will by default perform negatively the market. (in reality, hedge funds do not hedge all beta to zero, they hedge it pretty close to 1 so they track the market, but they probably under track it. This also leads to negative alpha) Where hedge funds play a role in investment management is when individuals can select hedge fund managers they believe will outperform. Professional investors, including fund of funds believe they can do this, and some will do this, some won't and the total will net to less than zero. [[Added in response to additional point below]] The paper cited is using an econometrics model which is using factor analysis to determine where the "biggest" source of performance comes from. Because beta is a factor, it will overshadow alpha automatically if beta is large enough. Alpha between funds will be destroyed in the model so the model will output zero alpha with enough funds. While beta will be persistent since by definition beta is a performance magnifier (for lack of a better term.) In other words, the conclusion in the paper is obvious, and not worthy of discussion. [[Added in response to Jesse]] Yes, if you are aggregate all money invested in hedge funds the average return will be lower than the benchmark that Beta is based off of. ETFs may or may not beat the benchmark depending on the ETF. Some have tracking error which causes them to not beat benchmarks. Also, you may notice that I am not arguing whether the OP is correct, I am generally agreeing with them, but the point is that his assertion is obvious and the cited paper is obvious and provides no real value.
- travisp 14y ago
  Yes it's beta and yes it's what's expected, but the hedge fund industry has historically claimed that returns are coming from alpha (investor skill) rather than beta (riskiness). There's the claim now that they are picking the right kind of beta to attempt to justify what papers are finding, but the outperformance that is exhibited by some hedge fund managers doesn't usually persist, suggesting that their selection of the particular risks were not a result of their skill. If the returns are actually from "dumb" beta, then the hedge fund fees are not appropriate for what you're getting. You're getting market returns appropriate for the amount of risk that's being taken, rather than outperforming, and then losing most of that to fees. Yes, exposure to beta can be a smart choice, but it can be done without excessive fees. >Where hedge funds play a role in investment management is when individuals can select hedge fund managers they believe will outperform Yes, this is the common refrain in mutual funds too: Buy the top performing managers, not the average fund. But the research shows that hedge funds that outpeform do not persist in outperforming. This suggests that the managers are not being particularly skilled in their selection of risk. Most fund of funds do not perform significantly better either -- there's little evidence that hedge funds are providing investors real value. Hedge funds are a status symbol for the wealthy, not a smart investment.
- jessaustin 14y ago
  So, the average hedge fund investor will make less money in her hedge funds than she would have made in an ETF? I realize that there are benefits in diversification, but travisp is generally correct.
- travisp 14y ago
  I can't edit any more, but I thought it might be helpful to others if I add this: I'm not really disagreeing with you either: I agree that the conclusion of the paper is mostly obvious, but it's valuable because it is important to show that beta is overshadowing alpha significantly in hedge funds. I could be wrong, but I would be surprised to see top hedge fund managers claiming that their results come from beta, not alpha. If they did, it would be harder to justify the amount they are paid during periods of good performance. I also do think that some manager skill exists in all areas of the market to a limited and varied extent. But, I suspect that even the hedge fund managers who do "provide alpha" capture most of it with their fees, leaving their clients with market returns or worse.

xntrk 14y ago

Fund of funds get hit pretty hard by fees since each fund takes out there fee and then the fund of funds also takes out it's fee.

hkmurakami 14y ago
IIRC the hedge funds take the usual 2 and 20 (though Renaissance Technologies apparently takes 5 and 36 now), then fund of funds takes 1 and 10 on top of that.

deleted 14y ago

[deleted]

outside1234 14y ago

This is not a surprise. Academic research has shown that 80% of funds underperform index funds and do even worse when you factor in costs. Its not sexy to say "take all your retirement money and put it into three funds: international stocks (eg. VEA), domestic stocks (eg. VTI), and domestic bonds (eg. AGG)" and rebalance it once a year to ratio based on your age but the research shows this is the most effective method of investing because it takes the emotion and costs out of it.

rogerbinns 14y ago
Vanguard even have target retirement funds (eg Target Retirement 2035 if you expect to retire around 2035). They automatically do the rebalancing for you - all you have to do is contribute while working and that is it! https://personal.vanguard.com/us/funds/vanguard/TargetRetirementList https://personal.vanguard.com/us/funds/vanguard/TargetRetire...

jhowell 14y ago

I think that it comes down to people. To become a C level executive or board member at a S&P company, presumably you've undergone a reasonably level of public scrutiny and shown the courage that Ben Horowitz sometimes references when talking about start up leadership, it takes to make the right and difficult decisions that benefit the business. Not every board member or executive, but the majority. The companies in the fund of funds, presumably don't have the same "blue chip" ratings of the S&P companies and their management may still be undergoing their personal tests of courage. In the end, in the absence of a extremely hot market - which could be a good or bad thing given the experience level of senior leadership, it's probably a better bet to go with the tried and true.

fduran 14y ago

The advice I got regarding stock market from a pro was to invest long term in the 3 indexes: "spiders" (S&P 500), "cubes" (Nasdaq 100) and "diamonds" (Dow Jones Industrial Average), seems solid, outperforming funds and without management fees.

jvm 14y ago
DJIA and S&P500 are highly correlated (intentionally so), also I'd recommend diversifying internationally.
artsrc 14y ago
If the market is efficient, then the correct investment is market weighted. You are missing the rest of the world and smaller stocks. This implies that you are missing some diversification that would reduce your risk.
- saryant 14y ago
  That's why I follow the basic three-fund portfolio advocated by contemporaries of John Bogle, founder of Vanguard: VTSMX, total US stock market, VTIAX, total international stock market and VBTLX, total bond market index. Three basic index funds each with very, very low fees compared to actively-managed funds. I'm at 60/30/10% respectively in those funds.
  - Evbn 14y ago
    Or roll them into an auto adjusting target retirement 20XX fund
    - saryant 14y ago
      I would if my 401k included one that wasn't terrible. I do use one of those funds for my Roth IRA though, I just wanted to limit my post to the principle, not the implementation.
larrydag 14y ago

wpietri 14y ago

Hey! They didn't even mention Long Bets! That's the site that registered the bet and is holding the money. http://longbets.org/ http://longbets.org/ Which I am going to pimp shamelessly here, as I wrote the code for it a decade ago. We have bets that go out many years. There's one that won't be decided until 2150. There's even one about how the universe will end. If you would like to make a similar long-term bet, either use the site or let me know; I'm glad to facilitate. As long as the bet is more than 2 years out and the stakes are more than $200 each, you're golden. We'd love to see the site used more to call out people making bold/crazy predictions. E.g., is somebody saying that NoSQL databases will rule the earth in 10 years? Do you think they're wrong? Tell them to put up or shut up! We'll put you both on record.

impendia 14y ago
My favorite: "Large Hadron Collider will destroy Earth."
- arbuge 14y ago
  I'd be willing to bet everything I have it won't. In fact I'd offer the same for any "XXX will destroy Earth" bet. Let me know if you're interested :-)
RyanMcGreal 14y ago
So did Stigler win this one? http://longbets.org/291/ http://longbets.org/291/
- wpietri 14y ago
  Thanks for the prod. They are now adjudicating all the outstanding best. Stigler did indeed win that one!
gwern 14y ago
One problem you guys have is that you aren't updating anything. I've been copying over predictions to predictionbook.com for the last 2 or 3 years now, and a number of predictions have expired - with no official judgment or anything.

rsobers 14y ago

Since hedge funds are subject to bigger swings, I suppose Buffet could be ahead for the next 5 years and then lose out due to a big upswing, no?