Swedroe: Hedge Funds Are Status Symbols

What was the biggest surprise to hit the markets in 2014? I think most investors would tell you it was either that interest rates fell or that the price of a barrel of oil fell by half. My own view is that there was a far bigger one.

For the 12 months ended August 2014, equity index funds and ETFs attracted $131 billion in net cash inflows, while actively managed funds suffered outflows of $55 billion.

These figures shouldn’t shock anyone, given the consistently poor performance of actively managed funds.

The real surprise is that, even though the hedge fund performance makes the returns of actively managed mutual funds look absolutely stellar, investors continued to pour money into them. In 2014, the HFRX Global Hedge Fund Index returned -0.6 percent. And for the 10-year period ending 2014, it returned just 0.7 percent, underperforming not only every major equity asset class, but even virtually riskless one-year Treasury bills.

The Biggest Surprise Of All

This type of performance is the reason behind the famous aphorism that hedge funds aren’t investment vehicles, nor are they an asset class—they’re actually compensation schemes.

Despite the miserable performance of hedge funds, capital continued to flow into the industry. Through the first three quarters of 2014, hedge fund industry assets grew by $190 billion. It was the ninth-consecutive quarter that the industry set a new high in assets under management.

In the following three months, investors allocated $3.6 billion in new capital to hedge funds globally, bringing full-year 2014 inflows to $76.4 billion, the highest calendar year of inflows since 2007. The industry’s total assets under management are an estimated $2.85 trillion.

What I’m driving at is the that the fact that investors continue to ignore a decade of miserable performance and keep pouring assets into hedge funds qualifies to me as the biggest surprise of 2014.

Reputable Critics Quoted

Perhaps this disconnect is what led Nobel Prize winner Eugene Fama to provide this warning about investing in hedge funds: “If you want to invest in something [hedge funds] where they steal your money and don’t tell you what they’re doing, be my guest.” Rex Sinquefield, co-founder of Dimensional Fund Advisors, went much further, calling hedge funds “mutual funds for rich idiots.”

That may seem harsh, but even the term “hedge fund” is an oxymoron. With the exception of dedicated short funds, most hedge funds don’t hedge anything. What’s more, the returns of most hedge funds are highly correlated with both volatility and the equity markets, and also are well explained by exposures to common factors (such as beta, size, value, momentum, quality, low volatility, term risk and default risk).

John Cochrane, well-known finance professor at the University of Chicago, put it this way: “Hedge funds are not a new asset class … they trade in exactly the same securities you already own.”

IIn his book “Unconventional Success,” David Swensen, chief investment officer of the Yale Endowment, provided these cautionary words: “In the hedge fund world, superior active management constitutes a rare commodity. Assuming that active managers of hedge funds achieve success levels similar to active managers of traditional marketable securities, investors in hedge funds face dramatically higher levels of prospective failure due to the materially higher levels of fees.”

As for funds of hedge funds, Swensen called them “a cancer on the institutional-investor world” and said they “facilitate the flow of ignorant capital.”

Cliff Asness, one of the founders of AQR Capital, offered this perspective: “One definition of hedge funds may resonate with many investors: Hedge funds are investment pools that are relatively unconstrained in what they do. They are relatively unregulated (for now), charge very high fees, will not necessarily give you your money back when you want it, and will generally not tell you what they do. They are supposed to make money all the time, and when they fail at this, their investors redeem and go to someone else who has recently been making money. Every three or four years they deliver a one-in-a-hundred year flood. They are generally run for rich people in Geneva, Switzerland, by rich people in Greenwich, Connecticut.”

A Sucker Is Born Every Minute

Despite the poor performance and ample warnings from such a distinguished group of academics and practitioners, high net worth individuals continue sinking money into hedge funds.

A new report from the Spectrem Group, titled “Use of Hedge Funds and Private Equity in the Portfolios of the Wealthy,” found that 42 percent of the ultra high net worth investors they surveyed invested in hedge funds. And the percentage that does invest in hedge funds increases with the level of wealth.

The question is why the ultra-wealthy continue to ignore the evidence. Is it the triumph of hype, hope and marketing over wisdom and experience?

Hedge Funds: The Ultimate Status Symbols

Meir Statman, a leader in the field of behavioral finance, provides us with another explanation: “Investments are like jobs, and their benefits extend beyond money. Investments express parts of our identity, whether that of a trader, a gold accumulator, or a fan of hedge funds. … We may not admit it, and we many not even know it, but our actions show that we are willing to pay money for the investment game. This is money we pay in trading commissions, mutual fund fees, and software that promises to tell us where the stock market is headed.”

He goes on to explain that some people invest in hedge funds for the same reason they buy a Rolex watch or carry a Gucci bag with its oversized logo—they are expressions of status available only to the wealthy.

Writing in 1973, John Brooks offered up this rationale: “Exclusivity and secrecy were crucial to hedge funds from the first. It certifies one’s affluence while attesting to one’s astuteness.”

Statman explains that hedge funds offer what he called the expressive benefits of status and sophistication, and the emotional benefits of pride and respect. In other words, they’re ego-driven investments, with demand fueled by the desire to be a “member of the club.”

Don’t Believe The Myths

These emotional benefits are what allow hedge fund sponsors to transfer money from the country club set to their own wallets.

With that in mind, investors in hedge funds would be well served to consider the following from another leader in the field of human behavior, Groucho Marx: “I don’t care to belong to any club that will have me as a member.”

The following, from Gary Weiss’ book, “Wall Street Versus America,” is a fitting conclusion:

“Hedge funds are the only component of Wall Street that is built pretty much entirely upon myth. Few areas of financial endeavor have been a subject of so many hoary myths, moronic half-truths, goofy speculation, once-true falsehoods, and knucklehead fantasies.”

Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.