Hedge Funds Underperform Stock and Bond Indices by Huge Margin
If you had put your money into hedge funds in 2005 and distributed it across the whole universe of hedge funds, you would have roughly the same amount of money today. By contrast, if you had simply bought the existing universe of publicly traded stocks and bonds and reinvested interest and dividends, your portfolio would have grown by half.
If the hedge funds performed much worse than either stock or bond index funds, what were they doing there in the first place? There are a few authentic geniuses in the hedge fund business, to be sure, who throw off spectacular returns regularly; there are a larger number of clever fellows who have a great idea one year (like John Paulson, who foresaw the housing collapse) and then lose just as spectacularly the next year.
And there are a very large number of Ivy-educated herd-followers in pink shirts and suspenders with no particularly notion of what they should do, some of whom take every opportunity to chisel out a speck of income by nefarious means.
So where are hedge funds finding suckers? Why hire HF managers if they are underperforming?
For the most part, hedge funds get their money from government pension funds and insurance companies who manage money for the small investors. Despite the hedges' miserable performance, institutional investors will continue to invest with them. Why?
The anemic American economy simply doesn't produce enough financial returns to meet the requirements of pension plans. Most pension plans need an 8%-9% return on assets to meet their obligations. But 10-year Treasuries pay 2%, and investment-grade corporate bonds pay 3% to 4%. Equities promise higher returns, but they are volatile: a pension plan that owns stocks during a big market dip will have to sell at the bottom to meet current obligations, and may never catch up.
Everybody is lying. The hedge funds. The government. The public to themselves.
Help the public believe its own bunkum. Every kid is above average in Lake Woebegone, and every hedge fund will earn excess returns, and every pension fund will beat the market.
Use index funds and sleep well.
The Market Value of Public-Sector Pension Deficits
States report that their public-employee pensions are underfunded by a total of $438 billion, but a more accurate accounting demonstrates that they are actually underfunded by over $3 trillion.
The accounting methods that states currently use to measure their liabilities assume plans can earn high investment without risk. Should plan assets fall short, as is likely, taxpayers are required to make up the difference. But the value of this taxpayer guarantee is not disclosed.
As a result, while states recognize that their public-employee pensions are underfunded, the situation is far worse than their accounting demonstrates. Without taking proactive steps now, taxpayers will be made to cover an enormous shortfall when the bills come due.
Key points in this Outlook:
State pension funds are underfunded by over $3 trillion; this is more than six times the $438 billion in underfunding the plans themselves report. Pension shortfalls far exceed explicit state debts.
Current state pension accounting practices are inaccurate and outmoded. Private pension plans would not be allowed to use such methods.
Market valuation of pension shortfalls more accurately shows the risk to state budgets and taxpayers.
Pension contributions, benefits, and retirement ages must be reformed, but this will be difficult until states adopt accurate accounting methods.
Hedge funds reversed three consecutive months of losses in June – although the average fund still underperformed both stocks and bonds for the first half of this year.
Hedge funds made a small gain of 0.05% last month, which took the performance of the first half of the year to 1.7%, according to data provider Hedge Fund Research.
This was below stock and bond benchmarks. The S&P500 Index (with dividends) was up 9.48%, while the Barclays Capital Government/Credit Bond Index was up 2.79%.
The premise of hedge funds is they have the brainpower and skills to make money no matter what the market is doing.
Some do - but very few. The HF industry is now crowded with mediocrity with Ivy degrees, elite connections and slick marketing - who can do no better than the local financial planner.
That said, there are some HF money runners who are worth the 2 X 20 fee structure (98% are not worth those heavy fees - some may be worth lower fees - others not worth a bucket of warm spit).
The great ones combine talent and experience with computer data crunching - running sophisticated algorithms to find hidden gold - the great asymmetrical trades.
The great asymmetrical trades have limited downside risk and massive upside potential. Otherwise it is gambling. Asymmetrical trades are usually based on a truth that most think false. Because of the crowded HF field, those are rare.
If you cannot find one of these HF stars, or cannot handle the volatility, I strongly suggest using index funds.
The Bank of America Merrill Lynch global diversified hedge fund composite index returned just 1.3 percent in the first half of 2012, well below the S&P 500’s 8.3 percent gain. Funds that focus on betting against stocks performed the worst, falling 7.1 percent as a group, according to the report.
The long side of options is one of the best and simplest ways traders can establish right-skewed, asymmetric trades—that is, trades that have the potential for large gains if they are correct, but only a limited loss if they are wrong.
Buying options is a fool’s game because, on balance, options are overpriced in the sense that implied volatility tends to be higher than subsequent realized volatility until expiration.
On balance, buyers of options will lose money. Sellers of options are providing insurance, and there has to be some incentive—read profit margin—in order for some market participants to be willing to take the unlimited risk of being sellers of options.
Just like sellers of home insurance will collect more in premiums than the claims they pay out, it is only reasonable to expect that the sellers of options will collect more premiums than the losses they realize from options that expire in-the-money.
You miss a critical point. The buyer of options actually has a big advantage—namely, the buyer can choose when to buy an option.
So while being long options all the time is a losing strategy, selectively buying options when there is a perceived large opportunity relative to the risk premium can be a very effective strategy, leading to right-skewed results.
Of course, the key is that the trader has to have some ability in selecting these opportunities.
"So while being long options all the time is a losing strategy, selectively buying options when there is a perceived large opportunity relative to the risk premium can be a very effective strategy..."
Yes, that is true. But it is also true that very few traders have the talent, skills and experience in finding these opportunities consistently.
Some may get lucky once or twice. Even John Paulson was only right once in this strategy - his recent performance is poor.
Its 100 hedge funds to make a market to save the values opened and gives a better opportunity in the market.
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