Advisor Blog

I picked up Larry Swedroe's excellent new book, The Quest for Alpha - The Holy Grail of Investing, at the local bookstore last week.  Swedroe is the Director of Research at The Buckingham Family of Financial Services and has previously written several very good books on investing.  Outside of academic journals, this book offers the most compelling and complete evidence-based case for passive investment that I have found. 

Most arguments against active management use data from mutual funds to make the point that the vast majority of actively managed funds underperform their benchmarks.  That's important, but what about the evidence from pension plans, hedge funds, private equity, individual investors, and behavioral finance?  Swedroe covers each topic and cites numerous academic studies in each area.

"The search for alpha is dominated by the "wizards of advertising" - and, for relatively sophisticated investors, by the "wizards of overconfidence." -- John A. Haslem, Professor Emeritus of Finance, University of Maryland

"...a clear and concise message that is supported by decades of research" -- Dr. William Reichenstein, CFA, Professor of Finance, Baylor University

If you've read The Investment Answer, this book is an excellent next step in your education process - it's listed in the library section of our website where you can click on the picture of the book's cover to purchase it through Amazon. We've discussed the evidence based on mutual funds previously, but in subsequent articles, we'll examine the evidence from other sources presented here.

There is a lot of mystique surrounding the hedge fund industry and many investors think that hedge funds are exclusive investment vehicles for the wealthy that somehow produce outsize return without taking on additional risk.  Financial economists would tell you that idea is ridiculous, but it certainly persists.  In fact, there seem to be plenty of people that are happy to pay the typical "2 and 20" fee that most hedge funds charge.  That means paying 2% of assets under management plus 20% of the gains (usually over a benchmark or "hurdle" rate) to the hedge fund manager. 

According to a recent article from Reuters, the hedge fund industry offered weak returns in 2010.  The article states that hedge funds, on average, returned only 4.52% through December 28.  The data is from the Hedge Fund Research HFRX index.  That certainly doesn't compare well to the market indices and pales in comparison to our portfolio results.

Another reason that investors give money to hedge fund managers, according to Gabriel Burstein, Global Head of Investment Research for Lipper, is that "they are looking for returns that do not depend on the broader market, and can therefore improve the performance of the investor's overall portfolio."  In other words, they are seeking to add an uncorrelated asset class to their portfolio.  Yet, according the article, "nearly every hedge fund strategy tended to move in synchrony with the markets and with other hedge fund strategies this year."

Numerous studies chronicle the bad behavior of typical individual investors that seem doomed to buy just before a crash and are drawn into buying the most recently fashionable sector at its peak.  But, are "sophisticated" institutional and wealthy hedge fund investors any different?

An interesting new study by the European School of Management examines how investors allocated money to hedge funds from 1994 through 2004.  Baquero and Verbeek, in "Style Investing: Evidence from Hedge Fund Investors", found that recent performance was the most prominent reason for the selection of a particular hedge fund and that for every 1% of extra return over the past three quarters, the average fund attracted an additional $9M in new assets.  And, predictably, the study also finds that "there are no significant differences in subsequent performance between those styles favoured by investors and those less favoured."

It seems that much like the supposedly dumb small investor, pension funds, endowments, and wealthy investors ended up chasing past performance - one of the behaviors that we have long known produces underperformance.  Such behavior is much more likely to reward the hedge fund managers than their new clients.