Guys, just checking in with some observations I had in the fund space. I have been a buy side strategist for most of my career, and lately I’ve been asked by clients and readers on why most active money managers fail to beat their benchmarks. Just want to share my experience on this issue, and would be interested to see what others think.
Why funds underperform
Most hedge funds that are actively investing underperform passive funds or their benchmarks. There are several reasons, and there are several studies about this. I would say the fees are probably the most important factor due to the drag on performance. The high number of managers is another important factor. Not every fund manager can outperform, and many are targeting the same benchmarks. This means that plenty of funds are doing similar investments, and opportunities are therefore diluted.
Also, the investment style that we are seeing today is pretty similar across different funds, at least from my experience (including at Neuberger Berman and Credit Suisse). I’d say the discussion is often about macroeconomics or major trends that are very long term. And a very long term also normally means a lower performance because we are talking about something that evolves slowly. On this note, I personally don’t think macro helps my investment decisions on a tactical basis, but the hedge funds where I worked do.
How often do funds outperform
The ratio between outperforming and underperforming years in the funds where I have been was about 1:1. Covid and the major shifts it brought are definitely part of the reason why the funds were underperforming, but it is always difficult to consider what is a “normal” situation and what is an outlier.
However, outperformance can also be misleading. In some of the hedge funds where I worked at, the benchmark was a relatively weak strategy that was being beaten. Same goes for other major funds out there. The relevance of the benchmark is an underestimated important selling point for some of these funds.
I must also add that investors often look at the S&P 500 as a benchmark even for fixed income investments, and this is of course a wrong comparison. Proper benchmarking is difficult, especially from an investor’s perspective, but we should always try to compare apples to apples.
Should anyone still park money with money managers
If the majority of active money managers are underperforming, the natural question becomes why should anyone pay a money manager an annual management fee rather than just put the bulk of his money in index funds.
People shouldn't, indeed. But the problem is twofold: (1) an average investor doesn't really know much about investments and finance; (2) the communication from hedge funds and investment managers is not clear, to say the least. Recent regulations are trying to improve point 2, but we, as investors, must learn more to overcome point 1. Once we have the tools, we not only make our best interest, but can also improve the industry as a whole, because these funds won't get the money and they will eventually disappear.
And once they disappear, winners will be much easier to spot. But the market is inefficient in all its respects, and it will stay like that for a while, so we should focus on learning and understanding the investment opportunities proposed to us.
Investment strategies
As to investment strategies that can outperform, I am partial towards systematic investing. When rebalancing is periodic and rational, systematic strategies do tend to outperform, or perform better than being constantly under adjustments. Fees are an underestimated drawdown factor, especially in niche asset classes, such as derivatives and crypto.
Trend following and momentum tend to provide better long term results, but it’s always difficult to assess depending on the approach, universe, frequency. Index rebalancing strategies can also be consistently profitable, although with lower returns due to the arbitrage nature of the strategies.
I’ll just conclude by saying that investing is difficult, even for institutional investors. So kudos to those beating a risk adjusted benchmark as well.
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