Hedge Funds- Great Wealth Transfer Vehicle

Hedge funds: A way for fund managers to make unbelievable profits by convincing wealthy investors, pensions, and trusts, they have discovered a way to achieve high returns without commensurate risk. Qualifies as one of the greatest wealth transfer vehicles in modern times.

~ Dan Solin, author of The Smartest Retirement Book You’ll Ever Read

We have often written about the perils of hedge funds.  It is astonishing to us to find an asset class that has performed so poorly but still attracts so much in assets.  When we question wealthy investors why they have invested in them, often the response is "that's what all of my wealthy friends do".  Investor psychology is a fascinating thing.  I recently finished watching the Madoff mini-series.  His sales tactics were legendary.  Almost without fail, he would tell every potential investor that the fund was closed (even though he desperately needed their money to continue his Ponzi scheme).  He knew something his prey often didn't:  people want what they can't have.  I believe hedge funds are marketed similarly.  They are only available to wealthy investors and it seems like you've "made it" if you can afford to get into them.  Like you are finally part of some sort of "club".

Unfortunately, we are here to tell you, that if you invest in hedge funds you may be enriching the manager instead of yourself.  From a recent blog post on the CFA website, here is a chart showing investor profits versus hedge fund fees over the last 17 years (click to enlarge):

Hedge funds

From the same article I found the following quote to be astonishing:

In fact, Lack's most recent data shows that hedge funds captured 84% of the profits and fees from 1998 through 2014; conversely, investors only 5% (fund of funds captured the remaining share).

Five percent!  Investors have risked their capital for the last 16 years and only received 5% of the profit!.  And people are still pouring their money into these vehicles.  Now I know this is the average and some have done much better, but investors need to wake up and understand how great the odds are stacked against them.  Hopefully this is a wake-up call for investors in hedge funds or those considering them.

Stock Market Crashes And The Recency Bias

We have written before about the recency bias, and it appears this phenomenon may be reappearing.  A report by the CFA institute shows that 33% of retail investors and 29% of institutional investors are forecasting another full-blown financial crisis in the next three years.  Now, I am not exactly sure what a "full-blown financial crisis" means but lets take a look at history since 1928 when the S&P 500 has lost 40% or more (peak-to-trough), which I think most of us would define as a crisis:

  • 1929-1930:    -44.7%
  • 1930-1932:    -83.0%
  • 1932-1933:    -40.6%
  • 1937-1938:    -54.5%
  • 1973-1974:    -48.2%
  • 2000-2002:    -49.1%
  • 2007-2009:    -56.8%

So, in the 88 years we can measure, we have 7 occurrences of the stock market crashing more than 40%.  By the way, 4 of them happened during the Great Depression which saw many fits and starts, so the crashes were interspersed with gigantic rallies as well.  Since the Great Depression, we only have 3 market crashes of 40% or more, and two of them happened in the same decade.  Is it surprising that 1/3 of investors are forecasting a crash?  It seems like it should happen every few years. That's how the recency bias works…we extrapolate recent events and assume they will continue into the future.

The reality is that stock market crashes tend to happen when people aren't predicting them.  How many people were forecasting the stock market to fall in 1999.  Who was calling for real estate prices to collapse in 2006?  Stock markets crashes start when sentiment is high and the future is bright.  Fast forward to today and investors are anything but optimistic.  We are not predicting the future.  We may see massive declines in the market over the next few years, but if 1/3 of investors are already expecting this, you have to ask yourself one important question:  is the bad news everyone seems to be expecting already priced in?



Our Magic Crystal Ball

What if I told you that I knew the future.   That I could tell you the return on an investment over the next 25 years (just to be clear, I have no idea…this is hypothetical).  My magic crystal ball tells me that this investment, would generate the following return over the next 25 years:

  • If the investment performs really poorly, you'll end with about 4 times your original investment
  • If the investment performs average, you'll end with about 15 times your original investment
  • If the investment performs fantastic, you'll end with about 53 times your original investment

Most investors would look at those numbers and think this looks like a pretty good investment.  Worst case is I only quadruple my money!  The really interesting part is that the results aren't hypothetical.  These returns actually happened in the S&P 500 (rolling 25 year periods) from 1927 to 2015.  You had to put up with quite a lot to get those returns.  The really bad return (where you only get 4 times your money) took place in the late 1920s through World War II.  While things look absolutely terrible, returns still managed to average 5.62% during that period.  The fantastic return started in 1975 and went until 2000, the greatest bull market our country has ever seen, with average returns of 17.25% per year.

Could the next 25 years be the worst we have ever seen?  Could they be better than our best ever?  Yes on both fronts.  The reality is no one knows.  But looking at the past, those that have a long enough time period to invest can feel very good about what the future might bring.

Stock Market Crash Of 2016- Mostly Irrelevant To Investors

As I write this the stock market is down about 10% for the year and even more if you go back to its peak late in 2015.  Oil prices have collapsed, global growth is slowing, and geo-political threats remain high (ISIS, elections, etc).  In the face of these threats, what are we telling our clients?  That this news is mostly irrelevant to their situation.  Before you think we are completely crazy, let us explain.

Most of our clients have a fairly long timeframe to invest.  Even ones who are already retired, still need their money to last for 10 years or more.  For those still working, they could live another 50 years.  Let me put it another way.  Our clients aren't selling all of their investments in the next year or two.  Why does that matter?  Time is the great healer when it comes to investing.  Below is a chart of rolling 15 year periods in the US stock market (represented by the CRSP 1-10 Index) from 1945 to 2015:

15 year rolling

Not only are there no negative periods, really bad times have seen 3 to 5% annualized returns (most people would accept those returns today!).  Here is the rub:  15 years is a really long time and a lot of bad stuff is going to happen during that stretch.  Can you imagine not losing faith during periods like the assassination of JFK, the reinstatement of the draft for Vietnam, the impeachment of a president, mortgage rates of 15%, the bankruptcy of several large companies, the near collapse of the global banking system, and countless currency and stock market crises around the world.  Investing is hard.  Not because of the analysis required, but the fortitude.

Data source:  DFA Returns 2.0  program

Which Is The Better Investment?

Let's say you inherited $100,000 from a relative and you were committed to investing that money for you and your family.  To make this even more hypothetical, let's say that someone approaches you with two investments described below:

  1. A growing technology company that has been expanding at a rapid pace.  They have grown their revenue at 30% per year for the past five years and look poised for continued growth.  They have seen significant stock price appreciation as the outlook seems very bright.
  2. An industrial supply company that has basically been stagnant for the past 10 years.  While they aren't losing money, the economy has been tough on them as more manufacturing is being famed out of the country.  Their stock has languished losing about 20% of its value over the past five years.

Which would you rather buy?  If you read this blog at all you're probably sensing a trick question.  You're right.  But before we get to the answer, let's go back to the companies described above.  I have defined textbook growth and value companies.  Growth companies tend to be expensive (high price compared to earnings) because they are growing so quickly.  Great examples today would be Amazon or Netflix.  The second company is a value company.  Their stocks are cheaper because their future prospects look dim.  Some examples today would be financial stocks and energy producers.

Most of us are drawn to the growth companies.  They have great stories and seemingly only know success.  Value stocks are boring and often have seen their stock prices get beat up.  But we have data that we can point towards to tell us which have been the better investment.  Below is a chart of rolling five year periods comparing growth stocks to value stocks.

value v growth (1)

As you can see, value stocks are the clear winner (when returns are above 0% value outperforms, below 0% growth outperforms).

  • Value stocks outperform growth stocks an average of 4.8% per year since 1926 (rolling 5 year periods)
  • Value stocks outperform growth stocks 83% of all rolling 5 year periods since 1926

So why should that be?  As an investor, the growth company seems like the safe one.  It would be hard to argue that Amazon is going to be out of business in 10 years.  But what about a small oil driller in the mid-west?  There is a tremendous amount of risk investing in a stock like this.  And there is your answer.  Value stocks are riskier than growth stocks.  In order for them to attract capital, they must offer higher rates of return to their investors.  More risk, but expected returns are higher as well.

We are in a period today where not only has the value "premium" over growth been trailing its average, but it has been negative!  As you can see from the chart it is fairly uncommon for value stocks to trail growth stocks for a five year period.  We believe this presents great opportunity for investors over the coming years ahead.  One last piece of information- while the example at the beginning of the article was used to make a point, we don't believe anyone should try to pick one (or a few stocks) to capture the value premium.  This is best done by buying ALL of the value stocks, which is reflected in the chart.  No matter what you invest in, putting all your eggs in one basket is never a good idea.

Data source:  Fama French HmL Research Index.  DFA Returns Program 2.0

Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.