Steben & Co., a Gaithersburg, Maryland headquartered fund of fund manager, has issued a white paper on the various unfavorable myths that it contends surround the hedge fund market. It says that four different myths are discouraging investments, and indeed that they are promulgated precisely for that purpose. The myths: that the smart money is getting out of hedge funds; that they underperform the equity markets long term; that they fail to provide diversification; and (the fourth alleged myth is a double barreled one) the fees are too high while the liquidity is too low. The most intriguing of their myth-busting efforts is the second, on the comparison with equity markets. So we’ll save that for last in this precis. Smart Money and Diversification The myth says that the proverbial rats are leaving the ship, so it must be sinking or at best in the vicinity of some jagged rocks. This idea has been prevalent at least since 2014, when the California Public Employees’ Retirement System exited its hedge fund positions. Steben replies, with respect to CalPERS specifically, that “the decision to redeem from hedge funds did not appear to be primarily motivated by a view of the future performance prospects of the investment class.” There were three other considerations at work: the smallness of the original allocation (hedge funds were only 1% of CalPERS’ portfolio); the politically unpalatable appearance of paying high fees to HF managers; and the real estate background of the newly appointed CIO. It was a decision, then, about optics and comfort levels, not about the “smartness” of CalPERS’ money. In general, the paper observes, there is no jumping ship. For example, “for endowments in aggregate, hedge fund allocations as a percentage of their total portfolio have been remarkably stable at close to 20% in recent years.” Another myth: hedge funds don’t provide diversification. Steben acknowledges a modicum of truth to this one, “many hedge funds may be less effective as diversifiers today than in the past.” But that issue is specific to equity oriented hedge funds and the event driven strategies. Many other strategies such as relative value, global macro, etc., and the funds that pursue them, still have low correlations to the S&P and thus can continue to play an important diversification role in a portfolio. Fees and Liquidity The general public impression of fees has long been dominated by the phrase “2 & 20,” a fee structure in which investors pay a 2% annual management fee as well as an incentive fee equal to 20% of profits. But as Steben observes, there has long been a downward pressure on fees, so the “2 & 20” is more honored in the breach than in the observance. With the pressure there has come to be a “growing dispersion in fees charged by different managers.” As for illiquidity: it comes with the territory, Steben says. There are daily liquidity vehicles that to some extent mimic specific hedge fund strategies, but this is only appropriate to the extent it can be done without creating a potentially disastrous mismatch between the liquidity of a fund’s assets and that of its liabilities. Equity Markets and the Pendulum As Steben acknowledges early on, Warren Buffett is now only “months away from winning his 10-year bet against Ted Seides on the S&P outperforming hedge funds.” So if the S&P can do better than hedge funds, why not simply invest in passively managed vehicles that mimic the S&P? To this, Steben gives three answers. First, “apples and oranges.” It may be no more sensible to use the S&P 500 as a benchmark for hedge fund performance than it would be to use it as a benchmark for bond market returns. Indeed, the “volatility of a broad basket of hedge funds has historically been closer to that of a bond index than a stock index.” Second, if we are going to use this benchmark, we may still consider the possibility that the superior performance of the S&P is a cyclical matter. Buffett was, so to speak, lucky in his choice of years. “The length of the recent cycle has been longer than that of past cycles, but this is likely explained by the extraordinary duration and magnitude of central bank quantitative easing that has occurred globally since 2009.” Third and finally, Steben says there is reason to believe that this pendulum is about to swing against the S&P. Valuations are very high and the central banks are tightening credit. Meanwhile, many hedge fund strategies could benefit not only from those higher rates but from wider risk premia spreads and the greater market dispersion that seems to be on the way. It might be added that Seides himself, the loser of that notorious bet with Buffett, has said much the same.
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