On Friday the S&P 500 dropped 1.25% and the NASDAQ fell 2.6%, driven by a sell-off in momentum names such as biotechs, FB, TWTR, AMZN, TSLA, etc.\u00a0 There was forced selling as leveraged hedge funds and other speculators liquidated positions.\u00a0 One prop trader told the Wall Street Journal<\/i>, <\/b>\u201cA lot of people had been performance chasing in these momentum names.\u00a0 Now they are panicking.\u201d\u00a0 A popular Biotech ETF, he noted, ballooned by $526 million in the first two months of 2014 but has since seen $280 million withdrawn.<\/p>\n
\u201cPlaying\u201d momentum names\u2014trying to get in and out before the crowd\u2014exemplifies the Greater Fool Theory<\/b>.\u00a0 TSLA may be overpriced, but it is going up and should become more overpriced.\u00a0 It typifies what many\u2014not all\u2014hedge funds do for a living.\u00a0 They trade short term, trying to exploit market trends and inefficiencies.\u00a0 One reason for their short time horizon: they are paid by the year and lose assets if they fall behind in the quarterly performance derby.<\/p>\n
Vanishing Inefficiencies<\/strong><\/p>\n Here\u2019s the problem.\u00a0 These days, there are very few inefficiencies to exploit and hedge funds have a great deal of money to put to work, trying to exploit these vanishing inefficiencies.\u00a0 Today copious corporate information is instantly available to virtually all investors.\u00a0 FactSet and Bloomberg can tell you nearly anything you want to know about a company; even Yahoo Finance has copious information.\u00a0 Conference calls are available to everyone.\u00a0 Company presentations are on the web before the CEO says a word to the investors and analysts at the Pierre Hotel.\u00a0 One solution to hedge funds\u2019 efficient-market problem is to use illegal inside information, but that has turned out poorly for several funds.<\/p>\n Whether it is used to play momentum names or to exploit non-existent inefficiencies in the stock market, short-term trading is not likely to beat the broad indexes<\/b>, especially on an after-tax basis.\u00a0 Trading costs are high, and the gains are short-term and taxed as ordinary income. Another hedge fund strategy\u2014trading macro trends\u2014is no more promising<\/b>.\u00a0 Macro trends are extremely difficult to forecast, and even if you get the economic trend right you may get the market reaction to it wrong.\u00a0 The European economy is still a mess; who could have predicted the Euro would stay as strong as it has?\u00a0 The Fed was unable to forecast the last three recessions, as we know from the Fed minutes.<\/p>\n Then there are the fees<\/b>.\u00a0 Let\u2019s say Sexy Hedgie has great performance, managing to beat the S&P 500 by 300 bps per year, with annual returns of 13% vs. 10% for the index.\u00a0 It charges 2% of assets and 15% of profits.\u00a0 On average that is 2% + (0.15 x 13%) or 3.95%, which means it underperforms an index fund.\u00a0 And small investors may pay a second layer of fees, to their bank or broker.<\/p>\n Bottom line:\u00a0 <\/b>Over the long run, most hedge funds will not deliver attractive after-tax returns.\u00a0 Yes, there are exceptions.\u00a0 There are super-traders such as George Soros and Steve Cohen.\u00a0 There are exceptionally talented investors such as the folks at Omega, who ran Goldman\u2019s equity strategy product for a couple of decades.\u00a0 Some other specialized funds may figure out a way to beat the market.\u00a0 But they are exceptions.\u00a0 Which means, quite simply, that hedge funds are not an attractive \u201casset class.\u201d\u00a0 <\/b>The average schmuck who walks in to J.P. Morgan with $30 million, and puts $10 million in a few hedge funds, is not likely to do very well.\u00a0 What should she do instead?\u00a0 Assuming the broad stock market is not wildly over-valued, a la 1999, I think she should buy the stocks of high quality companies, mostly U.S. names \u00a0but with a few world-class foreign companies.\u00a0 After fees and taxes, she will do much better than in hedge funds.<\/p>\n Learn from the Biggs, Mother and Son<\/b><\/p>\n A real world example is to be found in the late Barton Biggs\u2019 fun book Hedgehogging<\/b>, which I recommend.\u00a0 As I described in July 2012, Biggs\u2019 mother did very very well over the years by simply owning a basket of blue chip growth stocks selected by her husband (who was a professional investor) and her sons.\u00a0 Biggs estimates that her real purchasing power rose 12% annually for about three decades.<\/p>\n Contrast that performance with that of her hot shot Wall Streeter son.\u00a0 After he left Morgan Stanley in 2002 Biggs could not bear the thought of hanging around Greenwich and Palm Beach all week long, so he and two friends set up a hedge fund, Traxis Partners.\u00a0 In 2004 they fell upon a great macro insight, which they researched to death and concluded would be a big money maker.\u00a0 They decided to sell short oil.\u00a0 They reasoned that oil prices were at an all-time high, global output was increasing, global demand was slowing, and the U.S. strategic petroleum reserve was full.\u00a0 With oil trading at $40, their elaborate regression models revealed to them that the equilibrium price was $32.50.\u00a0 The trade was a disaster; global demand was much stronger than they figured, and hurricanes in the Gulf of Mexico added to their pain.<\/p>\n My take on Barton Biggs\u2019 oil trade is this: Are you kidding?<\/b>\u00a0 Why would anyone, especially three guys in a New York office building, bet on the price of oil? \u00a0(I am reminded of a friend, a successful Street economist, who told me the reason he survived so long in the business was that he never had to forecast oil prices or the dollar.)\u00a0 Why would anyone pay high fees to participate in a bet on the direction of oil prices, especially when they have the option of inexpensively investing in solid growth companies whose dividends will grow nicely over time?<\/p>\n Wealth Managers\u2019 Diversification Trap<\/b><\/p>\n Despite their obvious defects, hedge funds continue to be recommended by Wealth Management firms.\u00a0 I am looking at the monthly publication of a well-respected firm, which advises clients with a moderate risk tolerance to invest 10% of their assets in hedge funds and 39% in stocks, with the rest in bonds, commodities, private equity, and real estate.\u00a0 The rationale for this over- diversification is supposedly to limit risk, which is defined as the price volatility of the portfolio.\u00a0 Hedge funds may be a crappy investment compared with stocks, but they won\u2019t go down as much in a bear market, because they are hedged and not too tightly correlated with the equity market.<\/p>\n I don\u2019t buy this logic<\/b>, because for a wealthy long-term investor like Mrs. Biggs a temporary decline in stock prices\u2014or even one that lasts a few years– does not matter much.\u00a0 They are living off dividends; why should they care if stock prices decline for a few years?\u00a0 Let\u2019s get specific, with United Technologies, a diversified but moderately cyclical Blue Chip.\u00a0 In 2008 the company\u2019s EPS was $4.90, but then the world economy collapsed and EPS fell to $4.12 in 2009 and $4.74 in 2010.\u00a0 The stock price plunged from a 2008 high of $77 to a 2009 low of $37.\u00a0 OMG the stock was cut in half!!!\u00a0 But what happened to the UTX dividend? It rose 26% from $1.35 in 2008 to $1.70 in 2010.<\/p>\n The asset allocators in Wealth Management shops are basically telling clients to diversify out of sound long-term investments (common stocks) into bad one (hedge funds) to avoid declines in the quoted value of their securities, even though they are mostly living off dividends and don\u2019t need to sell at the bottom of the market.\u00a0 This is bad advice, in my opinion.<\/p>\n The Wisdom of Warren<\/b><\/p>\n For some reason Buffett groupies tend to overlook one of the major reasons for his success.\u00a0 He does not try to time the market and does not care if one of his long term holdings\u2014WFC, KO, IBM, AXP, or whatever\u2014declines in price during a bear market.\u00a0 He recently directed that a trust for his ex-wife invest 10% of assets in cash and the other 90% in a stock market index fund.\u00a0 If, during a bear market, you need more cash than you get from dividends, you don\u2019t need to sell stock because you can spend the cash.<\/p>\n This makes a lot of sense.\u00a0 Anyone can do it, via mutual funds, by themselves if they want to spend the time, or with the help of an investment advisor who follows a sensible buy-and-hold strategy. The aim is not necessarily to \u201cbeat the market\u201d but simply to participate in the long-term success of companies.\u00a0 Transaction costs are low and so are taxes.\u00a0 One key reason this strategy is not followed more is that brokers and investment advisors feel they need to try to beat the market to justify their fees.\u00a0 You need to get over that \u201cperformance\u201d mindset.<\/p>\n Copyright Thomas Doerflinger 2014.\u00a0 All Rights Sreserved<\/p>\n <\/p>\n <\/p>\n <\/p>\n","protected":false},"excerpt":{"rendered":" On Friday the S&P 500 dropped 1.25% and the NASDAQ fell 2.6%, driven by a sell-off in momentum names such as biotechs, FB, TWTR, AMZN, TSLA, etc.\u00a0 There was forced selling as leveraged hedge funds and other speculators liquidated positions.\u00a0 … Continue reading