Hedge fund managers used to be called the Masters of the Universe but their sales pitch that they have unrivalled knowledge of the fundamental laws of the financial universe is now clearly a bust.
Fund managers hedging their bets with your money
Back in the 1980s, they were known as the Masters of the Universe: financial wizards who turned formulas into fortunes.
Today, every day that passes brings fresh portents that their universe no longer exists. While markets boom, they lose money.
Last week Bloomberg reported that while the US S&P index has put on a healthy 10 per cent so far this year, a whole slew of hedge funds – the traditional home of the MOTUs – have managed to make a loss for their clients.
And those clients include us, via company pension funds, foundations and endowments, who pay hedge funds hefty fees for their genius in finding ways to beat the market.
Yet, incredibly, many of those we entrust with our financial well-being remain under the spell of the MOTUs.
The most charitable explanation is that they think the under-performance is just a blip.
There are two problems with that. First, despite their image, the MOTUs have been underperforming for years.
Over the last half-decade, the hedge fund industry has made an average of about 5 per cent per year for its clients. Which may not sound too bad – except the S&P has grown at over twice that rate.
Knock off the notorious “2 and 20” charged by hedge funds – 2 per cent management fee, plus 20 per cent of any profit – and that performance looks even more lamentable.
But the bigger problem is that the sales pitch of hedge funds – that they are masters of the fundamental laws of the financial universe – is now clearly a bust.
There are no fundamental laws; just an ever-shifting set of trends that come and go without rhyme or reason.
Compelling evidence comes from the track record of perhaps the best-known hedge funds: those using so-called “macro” strategies.
Operated by some of the most celebrated MOTUs, such as George Soros and Paul Tudor Jones, these funds are supposed to beat the market by canny exploitation of macro-economic effects like interest rate changes.
Having survived the global financial crisis of 2008, these macro hedge funds attracted huge client inflows for a few years – only to lose most of them again as markets failed to follow their rules.
The financial universe has got very weird of late. While it might seem we’re living through a period of huge uncertainty, the financial industry’s measure of market nervousness – the CBOE Volatility Index, or VIX - is at its lowest for 20 years.
From Brexit and Trump’s election to North Korea’s missile tests, nothing seems to faze the markets. They get a short bout of the jitters, and then resume their rise to new record levels.
This has caught out the macro hedge funds, who seem to have underestimated the confidence investors have in the state of the economy.
That confidence is widely attributed to the actions of central banks such as the US Federal Reserve and European Central Bank, which have used quantitative easing to stabilise the global economy after the financial crisis.
Economic factors don’t get any more “macro” than that, yet the macro hedge funds have still struggled to turn it into market-beating returns for their clients.
In a bid to do better, hedge funds are increasingly turning to computers for insight.
Some have adopted so-called momentum strategies, where computers try to spot trends caused by the sluggish response of investors to news, both good or bad.
This seems to work well – until it doesn’t. According to Bloomberg, the current performance of hedge funds using momentum strategies is the worst since records began 30 years ago.
Many hedge funds are hoping sheer number-crunching ability will show them how to beat the markets. From analysis of car parking outside supermarkets to forecasts of harvest yields in Asia, computers are being used to find market-moving signals in so-called Big Data.
If the aim is to attract investors, touting a Big Data approach seems to work. A recent survey by Barclays found that more than two-thirds of investors already think hedge funds offering such a “quant” or “systematic” strategy are outperforming their peers.
But if the aim is to hold on to them, it’s likely to fail. According to the report, there’s little evidence these strategies will work long-term.
Such pessimism is backed by countless examples of how easily computers can be fooled into seeing significance in random patterns – or fake ones. The US Securities and Exchange
Commission is pursuing companies for planting false internet stories specifically designed to fool computers into issuing buy orders.
In the end, the best hope for the MOTUs lies in a number, plus ignorance of a statistical quirk.
The number is 85 per cent. That’s the failure rate of fund managers who attempt to beat the markets. Of course, it also means 15 per cent succeed – but here’s the thing: trying to spot these winners ahead of time is tough and expensive.
Many managers make the cut through pure luck, only to plunge again once their luck runs out. They then sink back into the pack of losers in what statisticians call “reversion to the mean”, pausing only to collect their management fee.
So what should savvy investors do? One person who claims to know is the savviest investor of them all: Warren Buffett.
For years the Sage of Omaha has insisted the chances of outperforming the market at all – let alone as well as him – are so low it’s not worth paying someone to try.
Instead, he’s told his heirs to put 10 per cent into rock-solid government bonds and the rest into a cheap tracker fund that just follows the S&P index.
Such simple so-called “passive” strategies are catching on among serious investors tired of the hyperactive bluster of the MOTUs. So far this year, almost half a trillion dollars has flowed into passive investments, the largest amount ever recorded.
Indeed, we may be witnessing a revolution in investor behaviour, one so fundamental it could influence the global economy itself.
That kind of feedback loop can have unexpected consequences that no one can predict.
But one thing’s for sure: the Masters of the Universe will gladly give it a shot using your money – plus a fee.
Robert Matthews is Visiting Professor of Science at Aston University, Birmingham, UK