Defend & Advance

March 10, 2008

The Active Indexer is back: Serrapere's portfolio outperforms in 2007 and early 2008.

 

Much like the New York Giants, who advanced their way to a Super Bowl victory on February 3, 2008, Portfolio A turned around a weak start to 2007 with a strong finish, thanks to a GIANT DEFENSE. As the quarterback of Portfolio A, I empathize with Eli Manning’s last-minute victory drive. Eli and I sweated out the early part of the season with a weak offense and an adequate but not fully blossomed defense. In the end, defense put us in a position to win. The "A" team’s shorts on low-quality stocks, high-quality longs, anti-carry trades and U.S. dollar hedges scored points in the fourth quarter of 2007. They then kicked off 2008 with impressive gains.

At times, my patience ran thin (as did the patience of NY Giant fans). I held my positions because I was convinced that we had the right plays to win in the market climate that I anticipated, and that eventually manifested. Being up 8.8% and besting the S&P 500’s 5.5% return in 2007 was satisfactory because we met our absolute return objective.

Gratification Comes From Playing With Style

The "A" team hedged market losses in 2007. In January 2008, Portfolio A rallied 4.9% while the S&P 500 (S&P) slumped 6.1%. Year-to-date through Feb-2008, "A" is up 8.1% while the S&P is down -9.3%. From A’s March 19, 2004, inception date through Feb-08, the portfolio has netted 57.2 % compared with the S&P’s 24.9% and the Hedge Fund Research Institute Investable Index’s (HFRX) 17.9% return, which works out to 12%, 5.7% and 4.2% annualized (Figure 1). Figure 2 compares the monthly returns of Portfolio A to the S&P from Jan-07 through Feb-08. The same comparison for nearly 48 months (Mar-04 through Feb-08) can be found in Appendix A (Figure 23).

Active Indexer aims to show how to build your own hedge fund. It is rewarding. Portfolio A has come through as a hedge fund without the associated baggage of what Steve Leuthold of The Leuthold Group, LLC calls the 2 and 20 crowd.1 Mr. Leuthold has been very critical of hedge funds. I aspire to attain his style, which Steve calls making it and keeping it, when the crowd is giving it back. We stand on the shoulders of others. Steve enables us to recognize true value. If you want a great manager, he is it!

It is time to pick a fight with the Greenwich/Hamptons elite over hedge funds that charge investors 2% management fees plus 20% incentive fees. If you consider their single- to low-double-digit returns—especially after you factor in the illiquidity, low transparency and the higher business risk associated with most partnership formats—the costs are too high, in my opinion. They will soon lower their fees or go out of business if more investors learn to build and manage their own hedge funds. Exchange-traded funds (ETFs) enable us to fashion our own hedged portfolios with or without 2 & 20 investment structures.

As Michael Steinhardt, one of the most prominent hedge fund managers of all time, said during a recent interview on "60 Minutes,"you have to be stupid to pay 2 & 20 for high single- or low double-digit returns.2 My own view is that for these absolute returns, investors should be paying no more than 2%-3% versus the 4%-6% annually that is typically paid to invest in most hedge funds. Those investors deserve a 50% discount. And today’s investors are getting less than they were before hedge funds got hot (in the early 2000s). According to Mr. Steinhardt, hedge funds provided net returns north of 15% yearly during the 1960s through the early 1990s.

Mr. Steinhardt’s observation is borne out by HFRX performance. During the sample’s first nine years (1989-1998), it recorded a 13.3% annualized return. Since 1998, this index’s annualized return has declined to 9.4% through 2007. In spite of a bull market since September 2002, HFRX has provided a paltry 6.5% yearly return. HFRX continues to hedge a sizable degree of market losses, yet investors are definitely paying more for less. Prior to year 2000, most hedge funds charged a 1% management fee plus a 15% or a 20% incentive fee; now it is mostly 2 & 20. With their lower returns and higher fees, hedge funds are too dear. In the future, the 2 & 20 scene will be reserved for a few star managers.

Warren Buffett’s Take: "The hedge fund mania will fade with time as have past manias." In a CNBC interview on March 3, 2008, Mr. Buffett explained his negative opinion. He does not expect thousands of hedge funds to harvest market-beating returns after deducting their high fees and trading costs. Mr. Buffett adamantly believes that it is difficult enough to beat thousands of your peers before customary fees, let alone in 2 & 20 structures.

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