Back to Drew's Views
December 11, 2019
Previous
Next

The First Step to Regaining Credibility

Markets

As equity indices romped higher throughout most of the last ten years, the long-short hedge fund industry increasingly came under attack. As we have written, much of the furore was unwarranted. Truly uncorrelated, zero-beta hedge funds were never meant to be a replacement for the S&P 500 (or the MSCI Europe, or whatever market proxy you use).  

Describing such a hedge fund as a lousy rip-off simply because it underperformed a 100% equity benchmark is preposterously naïve; and this foolishness has been particularly rampant here toward the latter end of what has been a tremendous decade for equities.    

credibility 1.png
He got it back.

In this piece, however, we are going to visit, and take, the other side of the argument.  Our view is that many purportedly long-short hedge funds implicitly encouraged this faulty comparison to equity benchmarks.  For them, the comeuppance is much deserved.  

For those hedge funds running a net long exposure during a raging bull market, even if the returns appeared optically reasonable, or at least satisfactory, they were anything but.  There is nothing special about running a 50% net long hedge fund portfolio, generating a 25% gross return over some period when the market is up 50%.   That’s what the average skill-less dart-thrower would have achieved.

And there is something very un-special about that same net long hedge fund charging a full performance fee on those 25% absolute returns, rather than on a beta-adjusted relative return.  In other words, a lot of hedge funds were charging performance fees when there was no alpha at all.  There were also many charging performance fees even when the alpha was negative.  This, we believe, is why the overall industry is broadly frowned upon these days, and finds itself in this predicament.  

To illustrate the problem here, let’s take it to somewhat extreme, but not crazy, levels.  Imagine an investor earning a 10.8% net return from a 1.5% and 20% hedge fund, annualized, over 25 years.  And then imagine his fund manager investing all of his fee proceeds into his own fund, and letting it compound with no fees over the remaining years.

By year 19 – under this fee structure – the manager has more money than the investor.

credibility 2.jpg

Even in a world with 4.8% net returns, the wealth transfer from investor to manager is tremendous.

credibility 3.jpg

As happens in free markets, the industry is waking up a bit, on both the manager and investor side, and is now easing up on both management and performance fees.  This is a step in the right direction.  Here is the same 7.5% gross return fund compared to a more reasonable 1% and 15% fee structure.  

The difference over the first few years is barely noticeable, and certainly not noticeable to folks (on both the investor and manager side) that are focused on short-term returns.  But when you stretch it out to 25 years, which certainly is closer to the actual time horizon of institutional investors, there is a $600K difference on what was initially a $1 million investment.  Sure, that difference may be 25 years down the road, but it’s the difference between having $3.2 million, or 19% more than $3.2 million.

Credibility 4.png

But even this isn’t reasonable yet, because we aren’t yet taking into account any appearance (or not) of skill.   There is no consideration of alpha generation in this absolute return paradigm.   Sure, if the L/S manager is truly running with a beta of zero [1] and 100% of his excess return is due to some special skill, then fine.  But for the manager that is running 50% long, he should have a performance fee hurdle that reflects that.

Here is the comparison to a more aligned fee structure, with lower management and performance fees, and a hurdle based on the hedge-fund’s beta (or net exposure).

Credibility 5.png

Here, I believe, we have arrived at a fee structure which gets closer to what is fair. It gets closer to aligning interests while maintaining incentives.  It gets closer to paying for skill, if skill exists.  

And the end result for the institutional investor is nearly 36% better performance than under the old, one day vestigial, paradigm of high performance fees without regard to alpha. This is where the industry should go.      

FOOTNOTES

[1] And this argument could be made not just vs. the market factor, but against other known factor exposures known to systematically generate long-term excess returns, including momentum, value, quality, BAB/Low-vol, and in some cases, size.

Download PDF

Topics

Markets

DISCLAIMER

The views and opinions expressed in this post are those of the post’s author and do not necessarily reflect the views of Albert Bridge Capital, or its affiliates. This post has been provided solely for information purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The author makes no representations as to the accuracy or completeness of any information in this post or found by following any link in this post.

YOU MIGHT ALSO LIKE

Text Link

Heading

Lorem ipsum dolor sit amet, consectetur adipiscing elit. Suspendisse varius enim in eros elementum tristique. Duis cursus, mi quis viverra ornare, eros dolor interdum nulla, ut commodo diam libero vitae erat. Aenean faucibus nibh et justo cursus id rutrum lorem imperdiet. Nunc ut sem vitae risus tristique posuere.

Text Link
Text Link

Sell in May and Go Away?

Turns out there may actually be something to the old Sell in May and Go Away adage - at least over the last 80+ years.

Markets
Asset Pricing
Read More
Text Link

If Growth Stocks Sell Off Will They Bring Value Stocks Down with Them?

Growth stocks crushed just about everything from 2017 through 2021. Not that they necessarily will, but if they do give back some or all of their gains, given their weightings, times will be tough for broader indices. But what about the value names within them, will they sell off in sympathy as well? Of course no one knows, including ourselves, but we take a quick look at behavior of value names as the tech bubble sold off from 2000 through 2002. This example may be worth some consideration.

Markets
Factors
Read More
Text Link

Stock Market History, Illuminated

Some year-end charts and tables asking some big questions about what comes next.

Asset Pricing
Factors
Markets
Valuation
Read More
Text Link

Which One Are You?

So, if you are in the taxi, what is your first move (and you can’t say “do nothing”). Are you trimming or adding?

Markets
Stock Picking
Read More
Text Link

Just How Cheap is Europe vs. the US, and Should it Be?

As it turns out, it isn’t that the people are paying a bigger growth premium for US Growth over European Growth; but instead it is that people are paying a (much) bigger multiple for US Value than for European Value.

Markets
Stock Picking
Valuation
Read More
Text Link

Are American Companies Better than European Ones?

If we again go back and start the clock on January 1, 1980, and stop it thirty years later on December 31, 2009, we see that the S&P 500 generated annual total returns (with dividends) of 11.5%. During that exact same period, guess what the annual returns of the MSCI Europe were? Also 11.5%. This last decade, however, things have gotten out of whack.

Markets
Stock Picking
Read More
Navigations
HomeTeamDrew's viewsPressContact
Disclaimers
Legal & regulatoryPrivacy policyCookies policy
How to get in Touch
info@albertbridgecapital.com

Subscribe to Drew's Views

No spam. Unsubscribe anytime.
Thank you! Your submission has been received!
Oops! Something went wrong while submitting the form.
© Albert Bridge Capital 2022
Website by SW10media.com
On the Relationship Between Gasoline Prices and Vehicle Demand
Sell in May and Go Away?
The Politics of Passive Investing
If Growth Stocks Sell Off Will They Bring Value Stocks Down with Them?
Stock Market History, Illuminated
Which One Are You?
Was Ben Graham a Quant?
Do Short Term Flows Permanently Affect Share Prices?
Just How Cheap is Europe vs. the US, and Should it Be?
Are American Companies Better than European Ones?
Rumpelstiltskin and Meme Stock Investing
Archegos, Disclosure, and Price Discovery
It's All About the Fundies
On Unlimited Upside
A Memo to Investors
Investors? Possibly you!
Avengers Assemble!
How Did This Even Happen?
Was “Value” Just a Hot Hand Thing?
The Hot-Hand Fallacy Fallacy Fallacy?
Cue the Camouflage
The Times that Try Stock-Pickers’ Souls
A Different Game?
Heads I Win
A New Ice Age?
Grandpa Stocks
Bubblicious?
On Negative Oil and Futures Prices
In Flew Enza
COVID-19 and Equity Markets
Regulators to the Rescue?
Perspective
We Don’t Make Pizzas
Ben Graham the Growth Investor?
Not a Bad Decade
On the Impact of the FAMANGs
Europe vs the US: Is it all about sector exposures?
Behavioural Finance is Finance
America’s Decade
Known Unknowns and Share Prices
Prediction, Publicity, and Paul the Octopus
Are Company Visits Good or Bad?
Everybody Was Kung Fu Fighting?
Voting Machines and Weighing Machines
The DCF is the Randy Watson of Valuation
The Sacrilegious Diaries: Measuring the Impact of Portfolio Turnover
Passively Irrational?
Imagine No Inflation
The Sacrilegious Diaries: The Benefits of Turnover
Stay in the Game
I’m Volatility?
Woody was Right
When You Can’t Wait For Tomorrow
James Harden and Alpha
Groundhog Day and Overnight Returns
Debiasing and Alpha
Peak “Peak Car” ?
The Right Way
The First Step to Regaining Credibility
The Futility of Market Timing
Visualizing the Arithmetic of Active Management
123 Years of the Dow
Sweet Emotion?
Share Buybacks, Bad Companies, and Bear Markets
Risk and Portfolio Theory
Keeping Calm and Carrying On
Reminiscences of a Stock Operator: The Volkswagen Chronicles, Ten Years Later
We’d Rather Not Sleep
Factor Timing, Should You Try?
The Mathematics of Maintaining Bet Size
The Grandfather of Behavioural Investing
On Sexual Chocolate and Semi-Annual Reporting
Island Economies and Risk
Build a Bear?
Data Science and Alpha
We’re all Value Investors
Hunting for Alpha
Career Risk, Alpha, and Contrarian Investing
Passive Flows and Wheelbarrows
God Bless the Shorts
Equilibrium Happens
Horses and Stocks
Peak Quality?
Bill Sharpe and Hank Aaron
Unwarrented
The Search for Excellence and the Loser’s Game
Fooled by Non-Randomness
Half Hearted Is Half Minded
Still Superman, but without the cape
122 year Dow Jones Histogram: Putting 2017 into context
Pegs, P/E'S and the Value Premium
Rick Barry and Lewis Carroll
Secular Winners and Value Investing
On Passive Flows, Smart Money, and Alpha
The Voting Machine
Prevous
Next
homeTeamdrew's viewspressCOntactDisclaimers