The Bear’s Lair: An honest world without hedge or PE funds?

Hedge funds and private equity funds have been the big winners in attracting money over the past 20 easy-money years. Yet more and more investors are choosing indexed portfolios, which take out the investment manager’s skill entirely. If you believe mutual funds can’t beat the market, why should you believe hedge funds and private equity funds can do so – without cheating? With indications that indeed some cheating has occurred, and that returns have become mediocre, these structures may well be headed for the ash-heap of history. Market integrity will benefit.

Modern financial theory has got its knickers in a twist. On the one hand, it celebrates index funds, which passively match the broad stock market indexes, while charging lower fees than actively managed mutual funds. So convinced are investors by this line of reasoning that index funds are due to exceed half the assets in the investment management business by 2024, according to a Moody’s study last year. Old-fashioned active mutual fund managers like Peter Lynch of Magellan have become the outcasts of the industry, underpaid and despised by the media, which has come to believe they add no value.

We are told that modern investment research is so good that price anomalies are instantly corrected, so active managers cannot beat the market averages. Indeed, modern MBAs are taught to believe that the Efficient Market Hypothesis “proves” that with good investment analysis readily available, it is impossible to beat the indices, and that the returns of all investments converge on an “efficient frontier” where risk and return are precisely correlated. Of course, this begs the question of why anybody would waste money doing the analysis, if no superior returns could be earned thereby.

If the Efficient Market Hypothesis is correct, then why do hedge funds and private equity funds exist? If financial theory says that mutual funds cannot beat the averages on a risk-adjusted basis, then there is no reason to believe that hedge funds and private equity funds should be able to beat the averages either. There is no magic sauce of superior investment returns that can be acquired by paying somebody 2% per annum plus 20% of the returns and allowing him to become a billionaire in a bull market.

From the investors’ point of view, it is much more satisfactory to pay the manager a fraction of a percentage point per annum, or a decent bureaucrat’s salary with 25% of his salary as an additional bonus at the end of the year if he does a good job. The investor will then get to keep effectively all the returns, since the bureaucrat will do just as good a risk-adjusted job as the gunslinger – and indeed, if the price of peanuts is low enough, so will a monkey with a dartboard.

The existence of hedge funds and private equity funds proves conclusively that investors do not actually believe in the Efficient Market Hypothesis. They are right not to do so; it rests on very shaky theoretical foundations, as discussed in Kevin Dowd and my book “Alchemists of Loss” (© Wiley, 2010). In practice, disbelieving efficient market theories is not incompatible with the observed reality that most managed funds fail to beat the market. Since investors do not live in Lake Wobegon, it is impossible for all investment managers to be above average, but the existence of Warren Buffett (at least for the first few decades of his career) and indeed Peter Lynch in his prime proves that it is possible for truly superior investors to exist.

They do not however appear to abound in the hedge fund industry. The average return of hedge funds in 2017 was 8.5%, which sounds quite reasonable until you realize that a simple “buy and hold” on the Standard and Poor’s 500 Index would have returned 21.2% in that year. In 2016, the average return on hedge funds was 5.4%, again feeble compared with the 12.3% return on the S&P 500 Index. Yes, hedge funds are supposed to be market-neutral, and they beat the yield on Treasuries in both years, but on the other hand hedge funds are a lot riskier than Treasuries. Certainly, there is nothing to justify their outsize fees, and investors are utterly irrational in paying higher fees than they would pay for a well-managed mutual fund.

The reason for the feeble returns on hedge funds is that too much money has gone into them in recent years. They arose in the late 1960s, when “gunslingers” offered extra returns in the fevered speculative atmosphere of that period, then fell into obscurity, until the funds they controlled exploded after the monetary relaxation of 1995. Because of their remuneration structure, hedge fund managers are most interested in attracting new funds to play with, then placing leveraged bets on the markets, in the hope that bull markets will more than repay the losses in bear markets. Whether they actually do a superior job as investors is of only modest interest to them once they have sufficient funds under their control.

Inevitably in the period of “funny money” hedge fund bad behavior has spread. The Financial Times last week had a detailed study of how a hedge fund managed by the Blackstone Group, no less, had played games with credit default swaps, buying a large position in the CDS of particular companies, then offering those companies favorable funding in return for delaying their interest payment for just long enough to constitute a technical default and cause the CDS to pay out. Technically, that probably does not constitute fraud; I’m sure all concerned had excellent lawyers.

CDS have always been a highly problematic product; I looked at the possibility of creating credit derivatives when I was running a derivatives operation in the mid-1980s, a decade before the CDS market appeared, and determined that there was no legally watertight, fraud-proof way of determining when a default had occurred – precisely the problem that has surfaced in this case. (I also determined that credit derivatives’ risk profile was unmanageably skewed – the feature that caused such problems in 2007-08.) With decades of bull markets and funny money having followed my musings in the 1980s, it is not surprising that other fools rushed in where this particular angel (?) feared to tread. But CDS remain a thoroughly unsound product, which should be wound down as soon as possible, however useful they appear to be at first sight. Regulators, if you must exist, kindly take note!

Like hedge funds, private equity funds have expanded far beyond their real usefulness (true venture capital, financing true start-ups, is a much more useful if difficult product that has attracted a decreasing share of institutional money since 2000.) They have always had an integrity problem – countless companies have been stripped and left for dead through private equity ownership. You only have to examine the sorry saga of Sears under the tender ministrations of Eddie Lampert to see how Main Street icons can be destroyed while the feckless owner carries out innovative experiments in not cleaning the stores, all while deploying astronomical leverage.

As with hedge funds in the 1960s, private equity funds came into being in the early 1980s to exploit an opportunity – extremely low corporate valuations in the stock market after two decades of inflation – and performed a modestly useful service for a few years in sharpening up managers who were running their organizations like the dozier kind of country club. But country club management has given way today to option-focused, “Greed is Good” management, removing most of the opportunities that existed for private equity to make a positive operating difference. Since around 2000 the industry has been focused on “financial engineering” — collecting money, deploying excessive leverage, and finding lucrative scams.

Because of decades of artificially low interest rates, hedge funds and private equity funds have attracted much more money than they should have done and have made their managers through excessive fees much richer than they should have. Their dominion has also lasted much longer than it should have and extended further than it should have. However, it is now becoming obvious to even the doziest institutional investor that these entities are subtracting value, not adding it, and that even the geniuses at the Harvard endowment will be better off managing the university’s gigantic portfolio themselves rather than entrusting it to a bunch of overpaid, over-aggressive shysters.

It may take a major recession and credit crunch to end the era of hedge funds and private equity funds, but for the rest of us, and for the U.S. and global economies, the pain will be worth it in the long run. Market integrity is a precious jewel, tarnished by both types of institution.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)