That time of year

It’s that time of year for forecasters to rejoice in the opportunity to produce forecasts for the year ahead. Economists like Christmas – it brings the gift of a spotlight for their year ahead projections. However, when those economic growth forecasts start landing in your inbox, it might be worth keeping the following simple charts in mind.

We look here at the US market (simply because it is the heartbeat of the market overall and is so influential, but the analysis holds equally elsewhere) and the annual relationship between the growth rate of the economy and the return on the S&P 500.

Chart 1 shows the annual nominal return for the S&P 500 from 1990 onward plotted against the annual nominal rate of growth in US GDP.

Quite strikingly, there is absolutely no relationship at all between annual nominal US growth and annual nominal US equity returns (look at those coefficients, zeroes everywhere).


Let us torture the data a little to see if we can squeeze something useful from it. Chart 2 shows the annual rate of growth of real US GDP plotted against annual nominal US equity returns.

No change, still irrelevant. Where the economy goes the market does not follow.


So, with that in mind, perhaps it is time to give your economist a break this year. Not surprisingly, we will not be winging our economic growth forecasts to your inbox.

It’s not the economy, stupid.

P.S. Here is the same chart for the UK.




Thoughts on private equity implied returns… not convinced

Although we do not invest in private equity we, nevertheless, have a view on prospective returns for the asset class and its position in a portfolio.

Private equity (PE) as an investment seems to have become increasingly popular over the last ten to twenty years. This seems to be not only because PE funds are extremely lucrative for their managers and for the major banks, as PE has also been increasing in popularity as David Swensen (former Yale Endowment Fund CIO) and the “Endowment Model” have gained notoriety.

The Endowment Model is best described in Swensen’s book “Pioneering Portfolio Management” (2000), encouraging investors to seek out and harvest the risk premia in, amongst other things, private equity.

Whilst “owner/principal PE” i.e. private equity investments in businesses owned and run by the principal has obvious and demonstrable benefits, we are less convinced of the attractiveness of “agency PE funds” i.e. funds of private equity investments run by a manager/bank.

Here’s why:

  • Firstly, there is now a very big body of research largely from the US, where the asset class has been around for longer and the data collected has been over a much longer period, which strongly suggests that PE returns are highly correlated to listed small cap public equity returns.

Back in 2009 the Brandes Institute published a paper titled “Is US Small Cap a viable alternative to US Private Equity?”; the results and conclusions of which have been repeated and replicated in multiple studies in the following years.

It concluded, “… based on long-term performance, small cap has been a viable alternative to private equity in seeking compelling returns”.

Of course, PE is less-liquid, more opaque and the search costs involved in finding and accessing good and persistently performing funds (when the average PE fund delivers returns no better than public equity returns) should also be borne in mind.

In addition, as Professor Ludovic Phalippou (Said Business School, University of Oxford), probably the leading researcher in the performance and risk characteristics of PE funds, has shown, the generally accepted method for performance calculation in PE funds systematically overstates PE fund returns.

As shown in his paper “The Performance of Private Equity Funds” (2009) “… a large part of performance is driven by inflated accounting valuation of ongoing investments and we find a bias toward better performing funds in the data. We find an average net-of-fees fund performance of 3% per year below that of the S&P 500. Adjusting for risk brings the underperformance to 6% per year.”

For those particularly interested, Phalippou has proposed an alternative, more rigorous method to the traditional “internal rate of return” calculation favoured by PE funds – see “A New Method to Estimate Risk and Return of Non-traded Assets from Cash Flows: The Case of Private Equity Funds” (2012).

So, the case that (a) PE fund returns are overstated and (b) PE returns are highly correlated with small cap returns, in our view, is strong and very compelling.

  • Secondly, at the risk of attracting a wave of abuse, it seems to us that a large part of the PE model seems to be buy a company, swap its equity for debt and leverage the balance sheet. Increasing the balance sheet leverage increases the return on equity and, all other things considered, that lifts earnings and thus lifts the price for re-sale. Simple – more debt = better.

In fact, that looks pretty evident in the data. The following chart shows net credit market debt issuance in the private non-financial sector (as a % of GDP) versus the US Small Cap Equity Index implied 10 year annualised return.


The chart is very striking. In the period from 1980 – 1990 there does not seem to be much going on, this changes abruptly after.

Starting around 1990, the correlation between small cap equity implied returns and net debt issuance is extremely strong.

As PE returns have a large debt component and are highly correlated with small cap returns and since small cap returns are highly correlated with small cap valuation, what we see is a debt/small cap valuation/PE synchronisation over the last twenty-five years.

The next chart shows the valuation of US small cap that corresponds to the implied returns in the first chart. Right now, small cap valuation, with net debt issuance running at 4% of GDP, is within a whisper of the highest levels ever and on par with 2000 and 2008… and we know about the PE investment returns for funds entered at those points (Preqin has the data, for a fee).

PE investments made at the top of the valuation cycle at high levels of net debt issuance are never, looking back, a good idea.


The same high valuation/low implied return position is evident in European small cap.

So, implied US small cap returns look unappealing, less than 6%, suggesting very unattractive returns for US PE. Although at least with a small cap stock portfolio it can be liquidated at will, something that cannot be said of a PE Fund.

The next time you consider PE, think if you might not be better off in a cheaper, highly liquid, transparent small cap ETF instead.



Emerging markets… is it time to go back in?

Following our recent blog note on the level of implied returns in the major developed markets, a look at emerging market equities might be appropriate, especially after a sustained period of underperformance. Could it be time to buy back into the dream? What does valuation imply for long run returns?

To recap:

  • The MSCI Emerging Markets Equity (EME) Index (local currency) has returned 10.8% annualised since March 2009 and 2.7% annualised in the last five years.
  • The MSCI EAFE (developed non-US) Equity Index (local currency) has returned 12.9% and 9.5% respectively.
  • The MSCI US Equity Market Index (local currency) has returned 18.2% and 14.3%.

The underperformance of emerging markets in the last five years is striking. 7 – 12% annualised underperformance versus developed non-US equities and the US Index.

The underperformance is clear when you look at the relative price/book ratio for the MSCI Emerging Markets Index versus the MSCI World Index. Emerging markets have gone from a 16% premium to a 35% discount since 2010.

Call us old-fashioned, but we still adhere to the view that emerging markets, with their relative institutional, social, political and economic frailties should trade at a discount. So, at least we are back on the right side of the axis and about half way to the relative valuation at the trough after the Asian crisis in the 1990s.


The question then becomes “Is the current discount sufficient to deliver an attractive, relative implied return premium for emerging markets versus developed markets?”

Here is the relative valuation of emerging market equities versus the EAFE Index (developed non-US markets) and the UK Equity Index:

  • EME at a 14% discount versus EAFE from a near 40% premium in 2010.
  • EME at a 21% discount versus the UK from a near 20% premium in 2010.



As we showed in a previous blog piece on expected market returns, the arithmetic of equity returns is very simple – implied returns are a function of four simple numbers:

  1. The starting valuation ratio.
  2. The ending valuation ratio.
  3. The growth rate in earnings per share over the holding period.
  4. The dividend yield.

Of course, returns can be made to look as attractive as you want if you make outlandish, non-evidence based and obviously biased forecasts for variables 2, 3 and 4 (assuming that we can agree on an appropriate measure of valuation to start from). All one must do is make up a sales story and fix the numbers to fit.

We prefer to let the data speak and on that basis we make the following assumptions:

  1. The starting valuation is the current MSCI Index price/book ratio.
  2. The ending valuation is the long run trailing median price/book ratio i.e. we assume that ten years forward the P/B ratio has reverted back simply to its run trailing median level. What could be more conservative?
  3. The growth rate of earnings per share (and the per share bit is important, especially in emerging markets where vast amounts of equity dilution takes place from net new issuance necessary to finance the growth in earnings) is assumed to be the long run trailing annualised rate of earnings per share.
  4. The dividend yield is what it is and easily observable.

Now, we can turn to calculating the implied ten year holding period annualised return for EAFE, EME and UK equity indices on the basis of those parameters (it should be noted that earnings per share growth, for example, is staggeringly stable across markets over long time spans).

  • The first chart shows the annualised implied return for emerging equities less the annualised implied return for EAFE (developed non-US equities) at monthly points over the last fifteen years.

A number of thoughts spring to mind: (a) investors in the 2007 – 12 period were actually prepared to accept a meaningfully lower implied annualised return in EME equities than in EAFE equities; they believed in the dream of perpetual motion in emerging markets that is at odds with all of the historical data set with the cross sectional correlation between equity returns and growth being negative; (b) investors today seem willing to accept a 1.5% annualised return premium in emerging markets.


  • The second chart shows the annualised implied return for emerging equities less the annualised implied return for UK equities at monthly points over the last fifteen years.

Again, UK investors appeared happy to forgo 3% annualised return in 2008 – 10 to chase the emerging markets growth dream and are happy to accept a 1.8% premium today to move from UK equities to the emerging markets.


Of course, besides valuation and long run expected returns under conservative, empirically-validated assumptions, there are other considerations:

  • Emerging markets have a higher downmarket beta than developed markets. That is to say, when the US market falls sharply the emerging markets fall far more substantially. Emerging markets offer no downmarket diversification at all.
  • We also need to consider other identifiable known factors in returns since, at the end of October, emerging markets had negative absolute momentum and negative relative momentum (versus the UK, US or EAFE). We would want to see positive absolute and relative momentum before we commit to emerging markets.

So, all things considered, the modest implied return premium in emerging markets, the greater drawdown beta, and the negative absolute and relative momentum versus the developed markets all suggest to us that there will come a better opportunity to move back into emerging markets. As Aristotle said “patience is bitter, but its fruit is sweet”.



What is the expected market return?

Often we get asked what our view is of expected returns and, although our investment process is not conditional upon a set of expected asset class returns, we thought it might be interesting to see what a passive balanced portfolio might be expected to return over the course of the next ten years.

We have set an investment horizon of ten years simply because over this time period there is a clear and statistically significant relationship between valuation and returns that is not seen at short horizon dates, certainly not at a one year horizon.

Our analysis is just to give a baseline for what the expected passive return on a balanced portfolio might look like over the next decade.

Starting with Equities: the total return you earn over any period is comprised of capital gain (growth in earnings and the change in the Price/Earnings ratio) and income (dividends).

Without showing some lengthy arithmetic, take it from us (for those of a more nerdy nature we can provide details of the equations and a spreadsheet should you wish) that the Expected Equity index Return (ER) can be closely approximated (from The Gordon Growth Model) as,

ER = (1 + g) * (End PE ratio/Start PE ratio) ^ (1/t) – 1 + Dividend Yield * (Start PE ratio/ End PE ratio + 1)/2

Capital gain and Income are separated.


g = the growth rate of earnings per share over our time horizon, in our case ten years

End PE ratio = the Price/Earnings ratio at the 10 year horizon date, we use the Price/Trailing 10 year average reported earnings

Start PE ratio = the Price/Earnings ratio today, we use the Price/Trailing 10 year average reported earnings

t = the time horizon, in our case this is ten years

Dividend Yield = today’s dividend yield

Now, you might say “if I knew the PE ratio in ten years’ time and I knew how much earnings per share would grow over the next ten years I would be a genius with perfect foresight and life would be easy!”. In fact, you would be correct in thinking that, so we obviously need to make some assumptions/forecasts.

As anyone who has spent time in our company knows, we don’t like forecasts and we have next to no time for forecasters.

(For a fantastic demolition of the futility of forecasting and the witchcraft of forecasters see the following wonderful papers by Dr. Kesten Green and Professor J Scott Armstrong, University of South Australia: “Simple versus Complex Forecasting: The Evidence” and “The Seer-sucker Theory: The Value of Experts in Forecasting

So, rather than forecast the inputs, let’s set them at “normalized” or long run trend levels,

We assume earnings per share growth is at its long run trailing rate over the next ten years, we assume the PE ratio in ten years simply reverts back to its long run historical median level. No forecasts to manipulate, no exaggerated claims, just more of the same we saw over the last 5 decades and more…

Moreover, we proxy expected inflation, needed to convert nominal into real returns, with trailing 3 year average inflation.

So, taking those inputs, we calculate the implied ten year annualized return for the equity indices in the US, UK, Germany and Japan and plot them with real cash yields and real ten year bond yields in each case to give you an “implied return curve”:

In all cases the real implied cash and bond returns are pretty much zero – that is what QE does for you (it drives them to zero to force you out along the curve seeking returns in equities, it drives the curve to the horizontal axis as it has done in the US).

The implied real equity index return in the USA is a measly 2.5%. It is far more attractive elsewhere but we should never forget the down-market sensitivity of non-US markets to the US.


What of a balanced portfolio? Well if we look at a 50/50 Equity/Bonds mix in each case, and a weighted average for a portfolio of all four markets, this is what we get:

A US balanced portfolio has an implied return of 2% – the standard annualized return assumption for most big US pension funds is 7-8% – with the implied real return below 5% in all cases. Interestingly, a weighted average (using equity index weights) is just 2.5%


Of course, it is possible to get more, but that implies that earnings per share growth  (from the starting point of record profit margins) exceeds its long run, and highly stable, trend growth rate and/or valuation multiples go significantly higher.

That would be the best case scenario and, like everyone we like to hope for the best, but a prudent investor always plans for the worst (the event that earnings per share growth is slower than trend or the valuation multiple falls below the long run median level at any point over the next ten years) and that is exactly how we approach portfolio construction.

In the best case our fund should produce solid returns and in the worst case it should substantially lessen portfolio drawdown.



The Dr. Fox lecture

As investors in our Fund and regular readers of our blogs well understand, we are firm believers in the “elegance of simplicity”. In accordance with Occam’s Razor, why make things more complex if the complexity adds little or no incremental marginal value and only means that there are more things that can, and will, go wrong?

We have had people say to us, ‘if you added a few bells and whistles, your strategy would be even more appealing’, ‘it all seems too simple’ or ‘why if things can be made so simple and understandable do others not do the same?’.

To that end, we thought you might find the following brief clip – “The Dr. Fox Lecture” – extremely illuminating. Just 5 minutes of your time will show you just how the desire for complexity and opacity is a trap for the foolish.

Back in 1970, a group of psychologists wanted to test the response of intelligent people to the machinations of a so-called “expert”, the fabled “Dr. Fox”. As you will see from the lecture clip, an actor was put in place to deliver a highly complicated lecture full of opaque jargon, contradictions and made up facts. He appeared smart, well informed and a master of his topic, in fact an expert. Unfortunately, what the audience did not know is that he was delivering a lecture of meaningless nonsense wrapped in pseudo-scientific jargon.

Despite the dense, complicated and absurd content, the audience ratings for the lecture were fantastic. The audience lapped up the complexity and pseudo-science; they couldn’t get enough of it.

That study, and others that have followed, shows that people actually value complexity, even when they cannot untangle it and do not understand it. In short complexity creates exclusivity (there are only so many of us smart enough to understand, of course) and exclusivity creates desirability (as an advertising and marketing executive well understands).

So, the next time you see a portfolio manager with a complex, multi-faceted, opaque portfolio with lots of moving parts just think of the fabulous Dr. Fox.



China’s threat in two charts

If, in fact, China is growing at the reported 7% target rate, it certainly is not evident in these charts.

Things which are produced have to be moved to market. The first chart shows Chinese Rail Freight Volumes (% year/year).


The second chart shows the Volume of Freight per Kilometre Travelled.


Rail freight in China is falling at the fastest rate (year/year) in over twenty-five years.

This certainly does not look like an economy hitting its targets and running at an enviable (even within emerging markets) 7% growth rate.

It looks like an economy that has slowed alarmingly since the second half of 2014. In fact, it looks like an economy going off the rails (excuse the pun).



Less than meets the eye…

When is policy easing not much of policy easing? In China.

The Chinese cut the prime rate and the reserve requirement for banks last week by 0.25% and 0.5% respectively.

That brings the rate cut to 1.25% for the year and the reserves requirement cut to 2.5%.

On face value, this is quite an aggressive move after a 2% devaluation in the exchange rate a few months ago.

However, in our view, there is far less to the easing than meets the eye.

Here’s why:

The deposit base of Chinese financial institutions is approximately $20 trillion. Up to the end of September, the reserve ratio (RR) cut will have released about $407 billion of liquidity into the system. This combined with an incremental $105 billion coming from last week’s cut gives a year-to-date injection of approximately $512 billion.

However, as the following chart (October’s reserve data is not yet available, this data only goes through end of September and thus does not include the impact of last week’s RR cut) shows, in the period through the end of September the central bank lost $329 billion of foreign exchange reserves as capital flowed out of the country.


A loss of reserves represents a loss of domestic liquidity that must be offset against the RR cut to see the proper extent of liquidity injections from the central bank. Quite clearly, in the first nine months of the year 80% of the People’s Bank of China’s (PBOC) liquidity injections from RR cuts flowed straight out of the door; just about $80 billion of liquidity appears to have been injected net from a relatively swift policy easing. That amount is actually irrelevant in a $10 trillion economy under such banking system stress. It is almost certain that reserves declined again in October, probably offsetting more than half of that month’s RR liquidity release.

Moreover, with the GDP deflator and the negative producer price inflation, the nominal prime lending rate has not declined at a pace to even match the price deflation, leaving real lending rates higher than they were at the start of the year.

In addition, despite the devaluation, the real effective exchange rate is also higher over the last twelve months and since the beginning of the year.

All in all, less than meets the eye when you look at the true nature of Chinese monetary policy. Higher real rates, a higher effective exchange rate and a trivial increase in domestic liquidity. Why might that be so?

Well one reason, perhaps, is that the PBOC is trying to fight two fires with one extinguisher. The capital outflow puts downward pressure on the yuan such that the PBOC must defend it if it is to maintain the dollar currency peg. It needs high real interest rates to hold capital in, but the consequence of higher real interest rates for horribly leveraged domestic corporates on wafer thin (if any) margins are painful. It appears that the rate cuts and the RR cuts are intended to show willingness to support the economy under stress without also compromising the peg.

As always, something must give. Will the Chinese allow the system to fail for the sake of the peg? No, we don’t think so. It reinforces our view that the yuan will be devalued significantly in coming quarters. The paradox is that the more they cut rates… the faster capital flows away, the greater the pressure on the peg and the greater the stress in the system that necessitates even more RR cuts. It’s a vicious cycle where cuts necessitate more cuts; easier to let the yuan weaken.

Of course, when you get almost 30% of your imports from China, and their currency weakens, the Japanese will come under increasing pressure for an even more aggressive QE stance to show that they are doing something, anything, to address a deflation storm heading their way. A weaker yuan also implies a weaker yen.


Why China really matters

Chinese nominal USD-denominated imports dropped 14% in the three months to September year/year (and 14% in the six months to September year/year) – the median growth rate since the end of 2008 has been +6% year/year in both cases.

  • In short, Chinese import growth has been strong since the onset of the financial crisis in 2008/9, reflecting a period of exceptional local policy stimulus.

To put this in to context, the chart below shows the proportion of the growth in world merchandise trade accounted for by various countries/regions since 2008:

  • China, an economy of approximately $10 trillion – about 12% of Global GDP – accounts for 32% of the growth in goods imports over the five years from 2008 – 13. China has been punching well above its weight.
  • The Asia region as a whole, so dependent on China, accounts for almost 70% of the growth in global Imports.
  • China and Asia accounted for 54% and 27% of the growth in exports over the same period.


Why is this so important? Well, the following chart shows domestic demand growth in the major regions/countries on a rolling five year annualised basis:

  • Real domestic demand growth barely hit 2% annualised at its peak over the period in Japan, the UK and the US and has not grown at all in the Eurozone.
  • When you have little or no demand growth you rely on foreign demand; in the case of the developed economies you rely on Chinese import demand to hold global growth up.


Collapsing import demand, as we have argued previously, is reflective of an alarming slowdown in Chinese manufacturing sector investment growth (as Chinese companies race to bring capacity growth more in line with the rate of growth in demand in the West):


This is not a cyclical but a structural adjustment – weak global growth, disinflation/deflation follow.

With the exhaustion of the effects of monetary policy, how long will it be before we hear arguments of the kind below from policymakers?

  • “look, government bond yields are near record low levels, we can borrow for ten years at rates of 2% or less (or thirty years at negligible rates), I think we should be issuing lots more debt to take advantage and invest that money in real, tangible things (like infrastructure) where surely we can find some projects with long run returns above the nominal/real cost of borrowing.”


  • “Bond yields are so low, let’s borrow money, build a ‘National Recovery Fund’ and invest all the proceeds in the equity market directly, the risk premium is positive and surely equity returns will exceed bond returns over the next ten to thirty years.”




Deflation and the Fed… what would Greenspan say?

September 24, 2015

For those of us that have been around a while, and can remember, back in May 2003 (in the aftermath of the burst of the greatest equity market bubble since 1929) Alan Greenspan, then Federal Reserve Board Chairman said the following:

  • “We at the Federal Reserve recognize that deflation is a possibility. Even though we perceive the risks as minor, the potential consequences are very substantial and could be quite negative”  (Alan Greenspan, Congressional Testimony, May 2003)

At the time, this came as something of a bombshell, for the Chairman of the Fed even to entertain the possibility of deflation was quite a surprise to markets.

We thought it might be interesting to look at the parallels between today’s US inflation picture and that of the Spring of 2003. The comparison is quite striking.

We looked at 180 individual line items in the total Consumer Price Index (CPI) and the 106 line items that pretty much make up the Core CPI:

  • The chart shows that currently 43% of the individual core inflation items are in annual deflation, that compares to 48% in the Spring of 2003 and 45% in late 2010
  • The annual core inflation rate is currently 1.8% versus 1.5% in 2003
  • We are currently seeing the same breadth of core deflation that we saw at the bottom of the cycles post 2000 and 2009 bear market crashes


We then looked at how annual core inflation for the 106 sub-components had changed over the last 6 and 12 months to see if there was any clear trend:

  • In the Spring of 2003 about 60% of the components had seen year/year inflation decline in the previous 6 and 12 months (a clear downward trend) compared to about 50% today


Interestingly, in 2003 we saw:

  • 48% of core inflation components in deflation and 60% with a clear downward trend

In 2015 we see:

  • 43% in annual deflation and 53% with a clear downward trend

Our thought is then, “What is so different?”

Greenspan was worried about deflation and yet now Janet Yellen appears to be itching to tighten. (Growth was strongly accelerating in 2003/4 and has been stuck at 2.5 – 3.0% in the last year or more, so that can’t be the reason).

Could it be the fabled “tightness of labour markets” argument, the so-called “Phillips curve” fed to generations of economics students purporting to link labour markets to inflation? (Along the way, countless economists seem to have lost sight of the fact that A. W. Phillips’ famous 1958 paper was titled “The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957” and said nothing about unemployment and consumer price inflation).

Well, here is the relationship between the US unemployment rate level and US average hourly earnings over the last 50 years:

  • Clearly, even to an untrained eye, there isn’t one. A lower unemployment rate does not push up wage inflation…
  • There is, truly, nothing in the historical data to show that a lower unemployment rate (a “tighter labour market”) implies faster wage inflation (or, for that matter, faster price inflation)
  • Look at it with lags, as changes, whatever way you like, the “tight labour market/higher inflation” thesis cannot be substantiated… another case, to paraphrase our hero Thomas Huxley, of “a beautiful theory and ugly facts colliding”



  • If Greenspan was worried about deflation in 2003, why does Yellen not share the same concern (especially with the Chinese banking system in the state it is in and a Yuan devaluation on the way)? Would Greenspan be considering another round of QE here? We are inclined to think it would be foremost in his mind if he were still Fed Chairman.
  • Tight labour markets/faster inflation concerns just cannot be substantiated by the data; that is no reason to tighten.
  • US consumer inflation is determined exogenously (outside the control of the Fed) by the vast global overhang of global supply. Inflation in assets, inflation in balance sheets and surging debt are endogenous (inside the control of the Fed). They should tighten to address the latter and lay to rest old ghosts of Phillips curves. God forbid we get more QE, the consequences will be even worse when the rebalancing and re-pricing of risk takes place…
  • Because Central bankers are raised to believe that consumer price inflation is the target variable, they completely missed the consequences of inflation in asset prices and balance sheets in the last two cycles (confusing a positive supply shock from Chinese over-investment and low shop inflation with a miraculous surge in underlying productivity growth and hence trend GDP growth) and risk making the same mistake again…



The hidden drivers of hedge fund performance

September 22, 2015

At the beginning of the millennium, hedge funds were en vogue. Institutional and private investors could not quite get enough of them, as they thought that these funds had the ability to perform regardless of the market environment. The industry went through a phase of rapid growth, and the number of funds as well as assets under management ballooned. The valuation of most asset classes increased, making the life of hedge fund managers and that of the bankers lending them money, quite easy and sweet.

The party went on until 2008, when hedge funds in aggregate lost at least a quarter of their value according to the most widely followed investment benchmark (the HFR Global hedge fund index). Smaller funds started to shut down. The asset class attracted a lot of bad press. Scandals such as the Madoff Ponzi scheme exposed the danger of investing with hedge funds and the importance of proper due-diligence. Overall, as Simon Lack explains in his 2012 seminal work on hedge fund performance, “The Hedge Fund Mirage”, between 1995 and 2012 investors would have been better off invested in treasury bills, which have done better with essentially no risk. Yet the industry as a whole continues to grow, now reaching an estimated $3,000 billion of assets under management in aggregate.

At MONOGRAM, we are firm believers in Occam’s razor, which basically states that the simplest way to achieve a goal is the best. We also observe that the financial industry broadly disagrees with us, putting a large premium on complexity. Simply put, complicated investments should perform better or exhibit less risk. This of course, is directly contradicted by the facts. For example, a balanced portfolio invested 60% in Global Equities and 40% in Global Bonds has outperformed hedge fund indices every single year but one in the last ten.

Apparently, even hedge funds managers themselves believe in the superiority of simple investments since they have over time derived a large proportion of their performance from the simplest investment available to them – cash deposits. How do they do that? Hedge funds are mostly, as their name suggest, “hedged” vehicles. Schematically, this means that they borrow securities against a small fee from their prime broker (a bank typically), sell them, and buy other securities with the proceeds. This process leaves the fund’s cash balance largely untouched. Hedge funds can then decide to invest their cash balance in the money market and get paid an interest against that. When interest rates are at zero such as now, the effect is trivial. However, US short-term interest rates have averaged 4.2% between 1990 and 2008. This massive tailwind to hedge fund performance is gone and nowhere near making a comeback.

Secondly, as more hedge fund capital chases the same trading opportunities, competition increases and returns diminish. In the 1990s, traders could easily make 3 to 5% per annum with a simple “cash-and-carry” strategy – arbitraging two similar securities (typically in fixed income markets) trading at different valuations by selling the expensive one and buying the cheap one.  Adding to that, a decent amount of leverage makes for very decent profits without much risk or work. Today, these trading opportunities have been completely arbitraged away.

The hedge fund footprint on some markets has grown to levels that makes them risky and no longer profitable. Such is convertible arbitrage, which involves buying convertible bonds and hedging away the various market risks, a process that effectively leaves a hedge fund with a free option on the value of the issuing company. This worked very well at the end of the 1990s and the beginning of the 2000s, at which point hedge funds owned an estimated 80% of all convertible bonds outstanding (a market estimated at c. $500 billion in the US). In 2007, when they started losing money on the other strategies they had in their books, their prime brokers (i.e. their bank) forced hedge funds to reduce their leverage, which they had used to the tune of c. 3:1. Hedge funds had no choice but to sell their positions regardless of valuations. As everyone ran for the exit at the same time, convertible bonds valuation went in free fall, and investors in this strategy lost on average 60% of their money.

Against all odds, the disappearance of trading opportunities, the increasing competition, and the disappointing performance has not taken a toll on hedge funds fees. Rather, the contrary can be observed. According to a 2014 JPMorgan survey, fees have increased from last year to an average of 1.69% p.a. management fee and 19.13% of gains (1.64% and 18.99% in 2013). This comes in addition to various costs such as administration, custody, legal, prime brokerage, trading and even office rent and salaries on occasions. Given that, simple models show that a hedge fund making 10 to 15% before costs and fees would four out of five years leave investors with annualised returns in the region of 7 to 8% net at best. In the long run, hedge fund managers capture an estimated 50% of the profits generated with your money. No wonder there are so many hedge fund billionaires and so many disappointed investors.