Quantifiably Nuts

There's something of an open secret in the financial quant world: it just doesn't work any better than passive investing. Every now and again yet more data appears to bolster that truth. Today's comes in James B. Stewart's column. A mother lode of quotes; enough to last a year.

But, here's the punchline:

Large investors are still pouring money into hedge funds. They added $1 billion during January and more than $88 billion in 2014, according to data compiled by the investment consultancy eVestment. Total hedge fund assets are now over $3 trillion.

Where's the punch?

Even as their high fees have minted scores of new billionaires, hedge funds have now substantially underperformed a simple blend of index funds -- 60 percent stocks and 40 percent bonds -- for three-, five- and 10-year periods. And the 10-year numbers cover the period of the financial crisis and the sharp decline in stocks -- the very calamity that hedge funds are supposed to protect against.

That last bit is the loony bit.

For those too bludgeoned by the remorseless drum beating from these here parts to go off and read the whole thing, just some of the high points.

"There's no money in being against hedge funds," [Simon Lack, founder of the financial consultancy SL Advisors and author of "The Hedge Fund Mirage"] said. "If you're a consultant and say, 'Put it in Vanguard,' they won't need you anymore."

Kind of the same sort of notion of web sites paid for by adverts: in the web site case, the client is not the user of the site but the various advert pushers; in the hedge fund case, it's the funds who are the real client.

Others I spoke to cited data suggesting that hedge funds have a lower standard deviation, a measure of risk, and higher risk-adjusted returns than stocks. But Mr. Lack warned that such data is necessarily backward-looking and does not account for the larger amounts of capital now invested in hedge funds. When he wrote his book in 2012, "I said hedge funds were overcapitalized and returns would go down, which is exactly what has happened," he said. "The best funds know this, which is why they're closed to new investors."

(my emphasis)

Once again, with feeling and three-part harmony: there's more moolah chasing non-existent real investment opportunities.

As always, the only way to avoid significant loss is to exit before that last straw lands on the camel's back. How to recognize when the straw is coming in for a landing? (Re)-read your Samuelson. Tidal shifts in moolah movements are what matters to the hedge funds and the pension funds and the .1% wealthy who seek them. (Why did they miss the silly acceleration in house prices, one might ask?) When there's tens or hundreds of billions of dollars in need of a resting place, buying a few thousand shares of a soon-to-skyrocket biotech isn't sufficient.

Simon Lack:

"There's an enormous amount of research that shows hedge fund returns aren't persistent. They revert to the mean. Of all the hedge funds I looked at, only 7 percent were consistently in the top 40 percent. What chance do you have of picking them?"