Daily Maverick

Would Warren Buffett or John Bogle invest in hedge funds?

Few topics get fund managers more emotional than investment fees. Few things destroy your retirement fund more than high investment fees. Few topics generate more interest than fund manager performance, or lack thereof.

Combining high fees with poor performance is bound to spark even more interest and debate.

This was highlighted when Sygnia recently announced it was shutting down its hedge fund of funds after 13 years. Sygnia sold hedge fund of funds (HFOF), which is a fund that invests in other hedge fund (HFs), thus adding another layer of fees to an expensive product. If HFs are bad, it should follow that HFOFs are worse.

Are HFs good or bad? This is the question most people are trying to answer.

No-one can answer this with 100% conviction. I posed this exact question when I interviewed John Bogle, the founder of Vanguard (the largest asset manager in the US, with more than $5 trillion in assets under management) in
2010.

He first replied, “That’s like asking me what I think of people. They are all different.” Mr Bogle did eventually give me his answer, but he first gave me context to understand his answer. I would like to give you the context now so that you can answer this question for yourself, rather than rely on companies or people that may have a vested interest in the answer.

To provide appropriate context, I will answer five questions:
1. What is an HF?
2. What returns do HFs target?
3. What do HFs charge?
4. What results do HFs achieve?
5. Are HFs good or bad for HF mangers and clients?

1. What is an HF?

National Treasury defines a hedge fund as an investment portfolio using any one or more of the following investment strategies: leverage (borrowing to increase your exposure to an investment), short positions (selling a security you don’t own with the expectation of the price falling) or derivatives. We use the abbreviation LSD to describe the most common HF strategies of leverage, short-selling or derivatives.

Using LSD fundamentally changes the nature and risk of an investment portfolio. For example, using derivatives can reduce or increase the volatility of a portfolio depending on the type of derivatives used.

“Traditional” investments like unit trusts and pension funds typically don’t use LSD.

In South Africa, the most popular HF strategies are long/short funds (60% of total), fixed income (14%) and equity market neutral (12%).

2. What returns do HFs target?

Every investment portfolio, including HFs, should have an appropriate benchmark that determines the portfolio’s targeted returns. For example, a South African Equity Investment Portfolio’s benchmark could be the JSE All Share Index (ALSI). The returns of the portfolio would be measured against (benchmarked) the return of the ALSI.

HFs are typically sold as a lower risk alternative to a traditional investment. Remember that hedge means to reduce risk. The summarised HF sales pitch goes like this: “We will deliver similar or better returns compared to
cash/the ALSI/A balanced fund, with less volatility”.

HFs should be benchmarked against the underlying investments they invest in. Sadly, most aren’t. Instead, HFs tend to select a benchmark that favours them. For example, most long/short HFs invest mainly in equities but use cash/short term interest rates as their benchmark. As equities mostly beat cash this strategy is likely to deliver benchmark-beating results more often than not.

This “outperformance” is not due to manager skill but rather the excess return from investing in a riskier investment or asset class. This benchmark is highly questionable, as the fund manager is investing their clients’ money in equities yet earning performance fees against cash.

Added to the complexity of an appropriate benchmark is the complexity of HF performance fees. While the “benchmark” may be cash, many HFs charge performance fees on any positive return, so long as the net return beats the benchmark (cash). Confused? You should be. Let me explain.

In 2017, the JSE All Share Index returned 21%, and cash (short term interest rates) 7%. Say you invested in a long/short HF that returned 20% with a cash benchmark. The 20% performance fee equals 4% (20% of the 20% return) and the return after fees is 16% (20% – 4%) that beat cash. So you can pay very high fees for underperforming the equity market. Investors should not consider this result to be skilful.

3. What do HFs charge?

HFs originally used a 2 and 20 fee structure, comprising a 2% annual management fee and a 20% performance fee. Due to fee “pressure”, many HFs have reduced the annual fee to 1%.

As previously noted, HFOFs are portfolios that invest in HFs and add another layer of fees, typically another 0.85% to 1% annual management fee and a performance fee.

HFs tend to trade more than traditional funds, thus can incur higher trading costs.

HF and HFOF fees can add up. For example, The Sygnia All Star HFOF had a 7.5% total expense ratio in September 2016. By any reasonable measure, a 7.5% fee is outrageous and qualifies for the title of fee-fleecing.

This fund returned -2.4% in the prior 12 months, so while investors lost money, the HF and investment industry (with trading costs) earned R7.5 million for every R100 million invested.

4. What results do HFs achieve?

There is strong evidence that most HFs do not deliver good results for investors, as HF assets are falling and Sygnia is closing its own HFOFs.

In 2017, the average SA long/short HF returned -0.3% 5 versus 21% from the ALSI. While one year is far too short to judge performance, and some HFs did much better, most research concludes that most HFs do not produce attractive returns.

Warren Buffett is a long-time critic of active managers and HFs. Buffett’s central thesis is that the high costs associated with active management detract substantially from long run investment returns without, in aggregate, adding any value overall.

In 2007, Buffett placed a $1 million bet to prove his point. He bet that over the next 10 years, a S&P500 Index Fund would beat five HFOFs, all with different LSD strategies, managed by the best HF managers.

In the following 10 years, the S&P Index fund gained 125.8% versus 36.3% for the HFOFs. The five HFOF returns over 10 years ranged from 2.8% to 87.7%. So not even the best performing HFOF came close to the index fund over 10 years.

5. Are HFs good or bad for HF mangers and clients?

While some HFs have produced attractive returns, the majority of HFs have not. This is similar to the performance of active managers, where around 80% fail to beat the index. The few funds that do add value are only apparent with hindsight.

HFs generate enormous fees for HF managers and consultants. Investment fees average around 3% for South African investors, comprising 0.75% for advice, 0.5% for the platform (LISP/product fees) and 1.5% for fund management, plus VAT.

While 3% is outrageously high, it pales in comparison with an HFOF’s 7.5% fee. It is reasonable to conclude that HFs have been good for their managers but bad for most of their clients.

Warren Buffett also believes HFs are good only for HF managers, not investors, stating: “When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds”.

Coming back to John Bogle giving me his views of HFs, he noted that there were many different types of HF strategies. This caused a selection bias, meaning that people can use a small sample to defend any view they had.

He reminded me that there is no reliable way to pick future HF winners because, just like active managers, past performance is not a reliable guide to future performance.

“They charge an awful lot and their failure rate is high.” So, there are many more negatives than positives.”

Mr Bogle concluded: “Don’t go there, unequivocally don’t go there. HFs are a departure from my rules of simplicity and common sense.”

For me that says all you need to know.

Steven Nathan is the founder and chief executive of 10X Investments. DM

 

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