Macro Tsimmis

intelligently hedged investment

Do hedge funds really outperform the market?

Posted by intelledgement on Thu, 01 Mar 07

When I was a kid back in the 60s and early 70s, my father taught me how to read the stock tables in the newspaper and we would discuss the relative merits of investing in companies digging up anthracite vs. lignite…why he was buying bonds in my college fund…how he decided which rental units to acquire up in Hunter, New York…but he never sat me down and clearly explained, “The bank pays you 4%, bonds pay you 6%, real estate returns 8%, and, in the long run, the stock market gets you 10%.”

“I figured I knew the market for ski-rental real estate best, so I wanted money there,” he says now. “Everyone I knew then was focused on looking at particular opportunities and trying to decide if they made sense or not. No one talked much about classes of investments aside from boring financial planners, and they were always much more interested in talking about risks than about returns.”

(Whatever…he’s now out of real estate and into stocks. LOL)

Another thing no one ever really explained to me is the difference between “return on investment” (ROI) and “compounded annual growth rate” (CAGR). It would have been great if someone had pointed out to me that “When you talk about an ROI of 6% vs. one of 10% on $1000, it amounts to an additional $40 over the course of a whole year—at 6%, you get $60 interest and at 10% you get $100 of interest—which doesn’t sound like much. But when you talk about a CAGR of 6% vs. one of 10% on that same $1000 over 45 years—say from age 17 to age 62—at 6% compounded over 14 years, the $1,000 grows to $13,764.61 and compounded at 10%, it grows to $72,890.48—so, then you’re looking at an additional $59,125.87! The same $1000, the same 6%, the same 10%…in the first year, the difference in the ROI is $40, but over 45 years, the difference in the CAGR is $59,000!”

Now I can’t reasonably kvetch about my father’s failure to explain hedge funds to me, as back in 1968, no one had heard of them. So my lack of appreciation of hedge funds—into the 90s I pretty much presumed they merely bought and sold covered puts and calls—has to be attributed to the facts that [a] my focus was on my publishing career and [b] I never qualified as an accredited investor back then (a prerequisite for investing in a hedge fund).

Well, the Quantum Group’s infamous 1992 short-sale of the British pound was a wake-up call for me (and no doubt many others). By the time Long-Term Capital Management crashed and burned in 1998, everyone knew that hedge funds existed, and a lot of us had a general understanding of the variety of strategies that they employed (which went far, far beyond hedging long and short equity positions with options). But what most of us still lacked was hard performance data. Hedge funds are enjoined from advertising—as their products are deemed unsuitable for the general public—which suits most of them just fine: fund managers tend to be a secretive lot, assured (or, so they say) that their investment methodology lends them a competitive edge and accordingly uneager to share much information about it.

Now we knew that hedge funds cater to rich folks—who tend to be more than average knowledgeable about financial matters—and we knew that the total funds under management was growing. Putting two and two together, a logical inference is that hedge funds on average were beating the historical 10% CAGR of the market. Well…is that actually the case?

In a word: “Yes!”

Of course there are organizations that track hedge fund performance, and one of these, Greenwich Alternative Investments, has been tracking hundreds of funds since 1988. It turns out that overall, the CAGR of the S&P 500 from 1 January 1988 to 31 December 2006 was 9.63%, which is just a shade below historical norms. During the same time frame, after accounting for management fees, the aggregate CAGR of all hedge funds tracked by Greenwich clocked in at 15.35%. As we know from the above example, this is a huge difference. If you invested $25,000 in 1988 and got 9.63% on it for 19 years, it would be worth $143,500. But if you invested it at 15.35% for the same 19 years—not that there is any self-respecting hedge fund that would accept such an insultingly paltry investment!—your same $25,000 would then be worth $377,000, better than two-and-a-half times as much.

Next question: which type(s) of hedge funds perform the best?

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