Dear Mr. Buffett_ What an Investor Learns 1,269 Miles From Wall Street - Janet M. Tavakoli [35]
Some hedge funds are betting on leverage and luck as if they are rocking horses. Instead of relying on rocking horses, they look to their prime brokers, their investment banking and bank creditors. The hedge funds not only gain access to leveraged financing—there must be more money!—the investment banks also provide trading strategies.
Richard Heckinger ran into many hedge fund managers during his multiyear stay as managing director at Deutsche Boerse. He believes that many of them have no financial savvy:
I am amazed at how many of them don’t understand the nuts and bolts of what they’re trading. I’ve met . . . several dozen over the last several years who are not too clear even on the concept of an “exchange” . . . most deal with their prime brokers and order up their strategies much like calling Domino’s and ordering a pizza.34
The barriers to entry into the hedge fund world are low, and there seems to be a philosophy in the global hedge world that “anyone can do it.” It seems all it takes to go from zero to hero is swagger and loudly trumpeted self-reported claims.
In the late 1990s, there were only a few hundred hedge funds. By the summer of 2008, the number was estimated at around 8,000 globally, and hedge fund management had become a $1.87 trillion industry. Most of the money is concentrated in large funds. Funds that manage more than $5 billion have 60 percent of the market share; funds that manage $1 billion to $5 billion have another 26.7 percent of the market share. Put another way, less than 3 percent of hedge funds control 60 percent of the money, and somewhere between 6 percent to 9 percent of the funds control around 87 percent of the money.That means more than 90 percent of hedge funds are chasing the remaining 13 percent of market share.35
Hedge fund managers often claim they can beat the S&P 500, mutual funds, and just about any other investment available to individual investors. Some hedge funds state that their goal is to achieve positive returns in both bull and bear markets. Others claim to speculate with the (usually elusive) goal of highly volatile but ultimately high returns. Quantitative funds or “quant” funds like LTCM claim their models help them outperform the market.
Survivorship bias distorts returns reported by hedge fund indexes since the low returns of failed hedge funds drop out of the equation. If anemic returns and total wipeouts disappear forever, then reported returns have a greater chance of creating an illusion of better performance than other investments.
Creation bias is an even bigger problem. In military terms, it is the strategy of rapid dominance through shock and awe. Only “successful” funds that show a track record of outperforming the market are sold to investors, while failed attempts to create a successful track record are never reported. The initial outperformance has a halo effect on later years since the long-term record will continue to carry its swelling effect, even if subsequent returns are mediocre. As more money flows in, the funds often cannot replicate outperformance, devolving into under-performers. Multiyear returns are rarely dollar weighted, so returns are overstated, because large slugs of new money are earning lower returns. As the funds grow, it is harder to make excess market returns, since it is harder to find those incrementally attractive new ideas and assets.
Size has its disadvantages. Warren Buffett and Charlie Munger project they can achieve a tax-efficient average annual return of around 10 percent to 15 percent for the next five years—a very respectable return—but it isn’t likely they will match the tax-efficient 27 percent plus average annual return of the past 30 years. Their strategy