Romancing Alpha, Forsaking Beta
The High Cost of Chasing Performance
Presentation by Barry Ritholtz The Big Picture Conference, October 8, 2013 McGraw-Hill Auditorium, NYC
How Does Your Brain Interfere With Your Investing?
Behavioral Economics
1. Herding, Groupthink 2. Experts: Articulate Incompetents 3. Optimism Bias 4. Confirmation Bias 5. Recency Effect 6. Emotions impact perception
Neuro-Finance
7. Anticipation vs. Rewards 8. Selective Perception & Retention 9. A Species of Dopamine Addicts 10. Endowment Effect of Ownership 11. Monkeys Love a Narrative 12. Cognitive Errors Impact Processes
This is your brain on stocks
Looking at Alternative Investments
What Dont You Know About Hedge Fund Investing
Some Surprising Hedge Fund Info 1. Hedge Funds manage ~1% of total financial assets (Yet capture an disproportionate amount of media mindshare). 2. Hedge fund 2&20% fees exert enormous drag on returns; 3. Total Asset Weighted Alpha generated by tiny % of managers (Non Gaussian Dispersion = Fat head/Long tail) 4. Many funds start out creating Alpha but morph into fee capture 5. Picking new & emerging managers is exceedingly difficult; (Your biases make the process even harder)
Hedge Funds = 1.1% All Financial Assets
Global hedge fund industry = $2.13T Given what a relatively small asset class this is, they receive an excess of media attention. Perhaps because so many hedge fund managers have become billionaires, they have captured the investing publics imaginations
HFRX Global Hedge Fund Index Performance Data
How Have Hedge Funds Done?
2012 = Returns equaled 3.5% versus S&P 500-stock index 16% 2007-12 = Lost 13.6% vs. S&P 500-stock +8.6% 2013 = Gained 4.52% YTD vs. S&P 500-stock +14.5% YTD
Source: WSJ, HFRX
Diminishing Hedge Fund Returns
Alpha has diminishing returns to scale because many strategies only apply to smaller stocks and/or prices move against managers if they try to execute trades that are too large. Source: WSJ
Hedge Fund Growth
1997 = $118 billion 2012 = $2.04 trillion.
1. 2. 3.
Talent Dilution Excess Size Correlation / Indexers
Optimism Bias at Work
The Daunting Math of Mutual Fund Manager Selection
1.Only 20% of active managers (1 in 5) can outperform their benchmarks in any given year; 2.Within that quintile, less than half (1 in 10) outperform in two out of the next three years; 3.Only 3% stayed in the top 20% over five years (1 in 33) 4.Once we include costs and fees, less than 1% (1 in 100) manage to outperform (net). 5.What are the odds you can pick that 1 in 100 manager?
Sources: Morningstar, Vanguard
Confirmation Bias in Action
56% said they invested in hedge funds for diversification purposes Hedge funds correlated with other vehicles, falling in crisis Is Your Original Investing theme valid? 81% of investors said Yes (as of 2009)
Is This Rational Investing?
Managers Capture Investment Profits Mostly For Themselves
From 1998-2010 hedge fund managers earned $379 billion in fees. The investors in their funds earned only $70 billion in investing gains. Managers kept 84% of investment profits, investors netted 16%. As many as 1/3 of hedge funds use feeder and/or fund of funds. This brings the industry fee total to $440 billion thats 98% of capture. Investors are left with $9 billion dollars merely 2%.
Source: Simon Lack, The Hedge Fund Mirage
Who Profits from Hedge Funds?
Source: Hedge Fund Mirage.via Falkenblog
Hedge Fund Manager Profit Capture
Does not include Survivorship Bias, self reporting. Assume +3%
Who Profits from Hedge Funds?
Source: Hedge Fund Mirage.via Falkenblog
Two Smart Guys
2 smart guys leave Goldman Sachs to set up a hedge fund; They raise $1 billion dollars: Performance: Year 1: +15% Year 2: +10% Year 3: -5% , (return capital) Earnings (2 + 20%): Year 1: $20m + $30m Year 2: $22m + $22m Year 3: $24m + $0 Total Comp = $118m (Total S&P500+Div=17%) (S&P500 = 14%) (S&P500 = 12%)
Comparable Compensation
Source: Forbes
Top Hedge Fund Manager Compensation (Hourly)
It takes the average family 18.5 years to make what these hedge fund managers make in 1 hour
Source: Forbes
How Does Your Brain Interfere With Your Investing?
Behavioral Economics
1. Herding, Groupthink 2. Experts: Articulate Incompetents 3. Optimism Bias 4. Confirmation Bias 5. Recency Effect 6. Emotions impact perception
Neuro-Finance
7. Anticipation vs. Rewards 8. Selective Perception & Retention 9. A Species of Dopamine Addicts 10. Endowment Effect of Ownership 11. Monkeys Love a Narrative 12. Cognitive Errors Impact Processes
What Should Investors Do ?
Understand What You Can and Cannot Do Well As Managers -How overweight in alt (PE/HF/VC) investments are you? -Focus on Asset Allocation (15 distinct classes) -Use Core & Satellite Approach to Reduce Temptations -Take Advantage of Mean Reversion via class rebalancing -Lower your expectations until the next 1982 comes along -Think longer term -Get Unsexy!
We have met the enemy, and he is us. -Walt Kelly, Pogo, 1971
Supplemental Materials
Paulson Hedge Fund
Manager Selection is Much Harder Than People Believe -John Paulson launched his hedge fund in 1994 -Hires Paulo Pellgrini in 2004 -Raised $147 million in 2006 for Subprime Bet -Greatest Trade Ever in 2006-07 -Assets under management had swelled to $36 billion. -Subsequent losses were 52% in one fund, 35% in another.
Pellegrini PSQR Hedge Fund
Manager Selection is Much Harder Than People Believe
Paulson gave Pellegrini a $175 million bonus . . . Response: F#$% you, I quit Formed PSQR in 2008 Returns: 2008 = 40% 2009 = 61.6% 2010 = -11% August 2010, Pellegrini returned all outside investor capital
Sources: Greg Zuckerman, The Greatest Trade, WSJ
Hedge Fund Attrition
When
a
fund
leaves
the
Lipper
TASS
database
or
stops
repor7ng,
the
database
lists
one
of
the
following
as
the
possible
reason:
Fund
closed
to
new
investment.
Fund
dormant.
Fund
has
merged
into
another
en7ty.
Fund
liquidated.
Fund
no
longer
repor7ng.
Program
closed.
Unable
to
contact
fund.
Unknown.
92%
of
funds
that
leave
the
database
are
assigned
to
just
three
of
the
8
reasons:
fund
liquidated
(36%),
fund
no
longer
repor7ng
(38%),
and
unable
to
contact
fund(18%)
If
a
fund
leaves
the
database
because
it
liquidated,
it
is
safe
to
assume
that
the
decision
was
based
largely
on
poor
performance
The
aPri7on
for
funds
that
reported
returns
for
the
month
of
December
2006
(which
covers
the
24
months
through
2008)
is
alarmingly
high-
29%
to
63%
of
the
funds
seem
to
have
disappeared
Based
on
these
aPri7on
rates,
one
can
expect
anywhere
from
20%
to
60%
of
the
funds
repor7ng
at
any
given
7me
not
to
last
through
the
next
24
months
Such
high
aPri7on
rates
can
have
serious
consequences
for
long-term
investors
Vanguard
also
reports
the
average
annualized
excess
returns
of
the
funds
that
disappear.
The
excess
return
is
calculated
with
respect
to
the
peers
in
the
hedge
fund
categories
Source:
hPps://www.vanguardinvestments.se/content/documents/Ar7cles/Insights/alt-vs-indexing.pdf
Underperformance:
The
majority
of
funds
sixty-two
out
of
100
failed
to
exceed
returns
available
from
the
public
markets,
a\er
fees
and
carry
were
paid.
There
is
not
consistent
evidence
of
a
J-curve
in
venture
inves7ng
since
1997;
the
typical
Kauman
Founda7on
venture
fund
reported
peak
internal
rate
of
return
(IRRs)
and
investment
mul7ples
early
in
the
funds
life.
The
cumula7ve
eect
of
fees,
carry,
and
the
uneven
nature
of
venture
inves7ng
ul7mately
le\
us
with
sixty-nine
funds
(78
percent)
that
did
not
achieve
returns
sucient
to
reward
us
for
pa7ent,
expensive,
long-term
inves7ng.
(hPp://www.kauman.org/uploadedFiles/vc-enemy-is-us-report.pdf)
A
report
by
the
Na7onal
Venture
Capital
Associa7on
(NVCA)
states
that,
It
is
interes7ng
to
note
that
2012
is
the
rst
post-bubble
year
in
which
venture
funds
collec7vely
distributed
more
cash
to
limited
partners
than
they
brought
in.
(hPp://www.prweb.com/releases/2013/5/prweb10770077.htm)
(http://smullaney.com/wp-content/uploads/2010/12/VC-Performance1.jpg)
Outperformance: Bain & Co. in their 2013 Global Private Equity Report claim that, despite falling returns (above) and increased volatility (top right), buyout funds still outperformed the S&P 500 (right).
Emotions & the Sentiment Cycle
Source: Ritholtz.com
for more information, please contact
Barry L. Ritholtz
Ritholtz Wealth Management 90 Park Avenue, 18th Floor New York, NY 10016 212-455-9122 Info@Ritholtzwealth.com
