Individual Exceptionalism and the building Hedge Fund backlash

When asked if we believe we possess attributes that are above or below the average, the majority of us will answer that we are above. More than a mathematical impossibility, this is an insight into the insatiable desire to be unique and superior to the crowd that fuels so much of human society. Lottery tickets, fear of dying in an airplane crash, and The American Dream all have their roots in the fallacy that I am somehow exempt from the statistical realities that shape our world. The financial markets, in particular depend on this belief, and there exists no greater concentration of Individual Exceptionalism than in the world of Hedge Funds.

From the promise of outsize returns made by the fund managers to the seemingly limitless appetite for extraordinarily high fees and limited investors' rights, the unregulated world of Hedge Funds depends very much on the belief that somehow the laws of the universe don't apply to me. The pitch is basically this: a bunch of phenomonally smart guys are going to invest your money in such clever ways that they will consistently and massively out-perform the market. In exchange for this privilege, you will pay them a management fee, typically 2% of your investment per year, plus 20% off the top of whatever returns they make for you. There are more than 10,000 such funds now, with well over a trillion dollars under management. The catch? Most times you can't just take your money back, and the investment strategies are almost totally opaque even to investors. What makes us think we know under which shell the pea is hidden?

After a decade of growing Hedgemania, a backlash is now brewing. There's more talk of regulation and, as this fun, fact-filled article in The New Yorker details, a growing body of academic work that points out the lie at work. The author, John Cassidy, profiles one professor in particular, Harry Kat of the Cass Business School in London. Kat has been systematically dismantling the myth of Hedge Funds and Hedge Fund managers. In one study, he and a colleague looked at 77 funds' performance between 1990 and 2000 and found that when adjusted for fees, 72 of them underperformed the market. Over 90% of them.

Other academics studying Hedge Funds have looked at "survivor bias" -- the positive skew put on performance statistics by the dropping out of failing funds. Factoring the failures' results back into the mix, they found that between 1996 and 2003 Hedge Funds made a not-so-impressive average return of 9.32%. Further research showed that 40% of Hedge Funds' returns actually depend on the performance of the market as a whole. In other words, of that 9.32%, only about 5.59% came from the ultra-secret Hedge Fund strategies cooked up by those super-smart managers.

Is this a case of the pool of talent being diluted by the appeal of the vast fees fund managers can garner? This is a tempting perspective to take, since it preserves the appealing myth of the uber-manager with massive returns and the idea of the heroic, generally. However, the article hints at the more probable answer:

[Kat] argued that even some of the most prestigious funds owe much of their success to luck. “You can be fortunate,” he said. “You can live off market trends for quite a while. As in credit spreads”—the difference in yields between different types of bonds. “Credit spreads start to come down, and you make lots of money in credit. A couple of guys from an investment bank’s credit desk jump out and start a fund. If they are lucky, the trend continues for another couple of years, and they will look like masters of the universe. But when the trend reverses, or when there is no trend left, they are in trouble. If a guy has done well for two years, what does that mean? He could be really smart, or he could be really lucky. If I had bought stocks at the end of 1997 and you had looked at me at the end of 1999, I would have looked brilliant.”

In other words, clever people find opportunities in the market and create strategies to exploit them, then create a Hedge Fund around those strategies, or incorporate them into an existing fund. Then the opportunity booms, fizzles or bombs. Only in retrospect do the successful strategies look like the product of brilliant insight. The failures are swept under the rug or publicized as the products of less-talented fund managers. The luck machine rolls on, and we continue to mistake it for a game that can be won, if only by the exceptional among us. Kat sums it up well

"... if you know that eighty per cent of hedge-fund managers aren’t worth the fees they charge, then the rational thing to do is to give up trying to find a super manager, and just go for a good, efficient diversifier instead."

The Music of Chance

The most puzzling & even troubling aspect of market dynamics - that the best experts can be out-performed by happenstance. This story of the leading contender in a CNBC stock picking contest is a good illustration. She's a waitress who has no trading experience, who describes her method:

"Part of this was luck," she says. "A lot of it was a gut feeling, some eenie, meenie, minie, moe, and common sense."

This can be seen as an example of what Nassim Nicholas Taleb describes in The Black Swan: The Impact of the Highly Improbable - the most impact comes from events that are impossible to predict based on previous experience. As the story about the winning waitress puts it:

... it's also sign of what Paul Auster once called the "music of chance." Picking stocks is about luck as much as strategy. In a field of 375,000 contestants with 1.6 million portfolios, someone has to finish first.

To me this means that the best fund managers and stock pickers and quant models at best can match the performance of the market, over the long term. If they beat the market occasionally, it's random luck.

What does that mean for our understanding of large system dyanmics and financial markets in particular? Clearly the best experts and models should be heeded in order to ensure at least the performance of the market, but the holy grail of consistent market beating performance is a long way off, if it is achievable at all.

ETFs based on intelligent indexing

A more recent obsession of mine are Electronically-Traded Funds, or ETFs. I'm particularly interested in the rapid evolution they are undergoing, from recreations of relatively static indexes like the S&P 500 or the Russell 1000 to more sophisticated, creatively constructed indexes.

A good example is the Claymore/Sabrient Insider ETF, or NFO, which tracks an index of companies experience a heavy volume of insider buying, taking the famous Peter Lynch quote to heart:

"Insiders might sell their shares for any number of reasons, but they buy them for only one: they think the price will rise"

Sabrient, an independent analyst firm in California, has a number of interesting indexes that form the basis for their collaboration with Claymore, but NFO does seem to be the most interesting, as this Smartmoney article concurs. Backtesting shows almost 18% gains over the past ten years, but that and $5 will buy you a Starbucks grande chili-frapp-ca-ching-weeno or whatever passes for coffee these days.

More interesting is this comparison of NFO against the S&P for the past year, which shows it basically doubling its performance and clocking in a healthy 22% or so. Not that past performance is any indicator of future triumphs. I'm also intrigued by Claymore sector cyclical ETF, but I haven't looked into it deeply enough to make a determination.

This kind of simple tweak to narrow a broader index makes intuitive sense to me. All the data is out there - all the SEC filings, all the econometric indicators - why not correlate selected indicators to cherry pick the stocks that have a better chance of outperforming the herd? Seems more like the Web 2.0 way to invest, to me.

Disclaimer: I own NFO and I'm besides I have very little idea what I'm talking about, generally.