Hedge fund poker game gets tougher

Some high-profile hedge fund managers have thrown in the towel in recent months and, with this shaping up to be a difficult year – hedge funds have suffered their worst start to a year since 2008 – further closures are inevitable.

The deteriorating global economic environment is not the only challenge facing hedge funds, however. The seemingly inexorable rise of index funds and passive investing strategies has profound implications for hedge funds and for ordinary investors seeking market-beating returns.

Increased disenchantment with the performance of active fund managers has resulted in ordinary investors flocking to low-cost funds that simply track market indices. In the United States, the percentage of assets invested in passive portfolios has more than tripled over the past 15 years. Index fund giant Vanguard now manages more than $3 trillion (€2.7 trillion), making it the largest fund firm in the world.

Fewer poker players

The problem for hedge funds is that there are now “fewer traders at the poker table to play against”, to quote veteran US-based hedge fund Seminole Capital Management, which announced in December that it was returning $400 million to investors.

“The game has changed,” the firm said. “We are not confident our model can maintain historical-like returns in the future.”

Around the same time, $8 billion hedge fund BlueCrest Capital announced it was returning clients’ money. The firm, which had produced $22 billion in profits for its investors over the previous 15 years, cited a number of reasons for its decision, including “ongoing secular changes in the industry, including trends in fee levels”.

Financial trading is a zero-sum game; every euro earned by one trader must be lost by another. That’s why traders have long liked to cite the old Yiddish proverb: “when a fool comes to market, the merchants rejoice”.

Unfortunately for hedge funds, fewer fools are coming to market these days. The amateur day traders of the late 1990s are gone, while ordinary investors are less willing to tolerate high fees from underperforming fund managers.

Seminole’s line about there being fewer traders at the poker table is not the whole story. Rather, it may be that only the smartest traders now sit at the poker table.

Billionaire investor George Soros once noted that access to European company information was "extremely rudimentary" during his early investing career, so much so that his own "amateurish" research made him a "one-eyed king among the blind". Access to sophisticated strategies and financial data means those days are long gone. Today, there are about 15,000 hedge funds in the world, controlling almost $3 trillion in assets. Compare that to 1990, when 530 funds controlled $39 billion in assets. Vanguard alone manages the same amount as the entire enlarged hedge fund sector.

Shrinking alpha

With less-skilled investors giving up and switching to index funds, markets are becoming dominated by the most sophisticated players. As the “dumb money” bows out, the remaining competition must by definition become tougher. As a result, it is becoming more and more difficult to deliver superior risk-adjusted returns, or “alpha”, to use financial lingo.

Larry Swedroe, investment adviser and co-author of The Incredible Shrinking Alpha, notes a recent study which found that 20 years ago, about 20 per cent of actively-managed funds delivered statistically significant alpha. By 2011, the study found, that number had dwindled to under 2 per cent. Essentially, markets may be becoming "overgrazed" to borrow the phrase used by researcher and former commodities manager Claude Erb. In a 2014 study, Erb noted that the outperformance associated with many of the best-regarded investment strategies was ebbing away.

For example, it’s long been established that small-capitalisation stocks have historically been associated with above-average returns.

However, Erb found that the size premium has almost disappeared. Similarly, the premium associated with value stocks has waned significantly over time, Erb found.

The reason for this change is simple – too many investors have become aware of apparent market anomalies. In a separate study, Does Academic Research Destroy Stock Return Predictability?, the authors examined 97 variables associated with stock market outperformance, as documented in 80 different studies. Following publication, the authors found, trading volumes increase in the stocks within the predictor portfolios. Post-publication returns plummet by about a third, destroying the edge associated with these strategies.

The drop-off in returns is especially obvious if the strategy is easy to implement – for example, in liquid large-capitalisation stocks, as opposed to illiquid small-cap stocks.

Persistence of momentum

Not all investment edges are necessarily doomed to disappear. Erb found that the premium associated with momentum stocks is still large, even if it has narrowed somewhat.

The approach of momentum investors is very basic: buy recent winners, sell recent losers. The importance of momentum has been documented in academic literature for more than two decades, but many investors remain sceptical. In his book The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Howard Marks of Oaktree Capital writes that momentum "isn't a cerebral approach to investing" before going on to dismiss "momentum investors and their Ouija boards, along with all other forms of investing that eschew intelligent analysis".

Marks is a highly successful and thoughtful money manager, so it is revealing that he appears contemptuous of an approach that has substantial empirical backing.

As Erb points out, this “high degree of disbelief in momentum” could be allowing its edge to persist. Nevertheless, there is no guarantee that this distaste will persist. A number of exchange-traded funds (ETFs) inspired by the momentum approach now exist; if they become more popular, the edge associated with the momentum factor may dissipate in coming years.

Ordinary investors

The implications of competition and “overgrazing” are not confined to hedge fund managers. Rather, they are profoundly relevant to ordinary investors hoping to outperform the stock market. In

The Incredible Shrinking Alpha

, Swedroe notes: “What so many people fail to comprehend is that in many forms of competition, such as chess, poker or investing, it is the relative level of skill that plays the more important role in determining outcomes, not the absolute level.”

In other words, it doesn't matter if you know a lot about investment, or if you read the Financial Times voraciously or Warren Buffett's collected letters on a daily basis, if your competition does the same and more.

Unfortunately, people tend not to grasp this crucial distinction between absolute and relative skills levels, as revealed in various studies conducted by Cornell psychologist David Dunning. Dunning found that if you ask people how well they ride a bicycle relative to others, they will typically give a high estimation of their abilities. They dwell on the fact they have no trouble riding a bicycle, but forget others have no difficulty either.

Ask them about a difficult task, such as juggling, and they will describe themselves as below-average, forgetting the fact that most people will be similarly poor at juggling.

Ironically, when investors hear that hedge funds and active fund managers are underperforming relative to the past, they may intuitively conclude that institutional investors are a lesser breed than that seen in the days of old. However, the opposite is true – the average manager is actually more skilled and knowledgeable than in past years, but so is the competition.

As the so-called dumb money recognises its limitations and migrates to a passive investing approach, the search for investing alpha becomes an increasingly difficult one. That's bad news for those left sitting at the poker table, whether they be hedge funds like Seminole Capital Management or ordinary investors seeking market-beating returns.