Hedge funds lose the edge, beaten by the US market index again and again

The poor performance of the hedge funds industry last year as well as in the last 10 years has prompted many to question their very existence. Are they really worth it?

Hedge funds have had a miserable 2012 as they returned just 3% to the investors. By contrast, the S&P 500 index was up 18% during the year. In other words, you would have been better off just investing in the stock market index and tending to your garden. So much for hedge funds generating ‘alpha’ – excess over the market returns. Indeed, they have failed, again and again. Hedge fund managers with degrees from prestigious universities such as Harvard, MIT, Stanford, etc, and with years of experience in financial markets have simply failed to exploit gaps and take advantage of the favourable market conditions.

However, if you thought 2012 was just an unlucky year for hedge funds, think again. What is more startling, however, is the fact that S&P 500 index has outperformed hedge funds in the last 10 straight years, except for 2008—the year Lehman Brothers went bust. Worse still, according to Goldman Sach’s David Kostin, a whopping 88% of the hedge funds underperformed the market last year alone. This is by no means a small number, given that majority of them are presumably smart. How come these smart hedge fund managers couldn’t ride on the market’s coattails which went up 18%?

Check our previous pieces on hedge funds over here: The myth of hedge fund prowess:  and Not much of an alternative:

Even big name hedge fund managers fared poorly. For example, John Paulson, who famously made $1 billion shorting the housing boom in America, too, lost money. According to The Economist, he lost 17% in the first ten months of 2012, after a 51% fall in 2011. According to Reuters, David Einhorn’s Greenlight Capital lagged S&P 500 and gained only 3.17%. Einhorn rose to fame after famously calling Lehman’s bluff and predicted it would be bankrupt. Among Einhorn’s great recent ideas was Apple at nearly $700 while the price now is below $500, at around $458.

The irony is that the Federal Reserve, America’s central bank, had created conditions so ideal for market participants to thrive. After all, the bank bailouts of 2008 made hedge funds supremely wealthy and the market went up. The successive quantitative easing and loose monetary policy meant that financial institutions, banks, and especially hedge funds had more money to play around with. The quantitative easing also artificially propped up various markets. It is also pertinent to note that hedge funds usually had access to the highest echelons of the government and privy to information that mutual fund and retail investors did not have.

How come hedge funds lost money? One explanation is that while it is true that hedge funds had more money to play around with, they simply had to play the same game, namely the long game, with other investors, mutual funds and retail investors. In other words, they couldn’t go short when they wanted to because the central bank had virtually eliminated downside risks by printing more dollars. Hedge funds were created to go long AND short and everything else in between, unlike mutual funds and retail investors who normally go long.

Another explanation is their sheer big size. The industry size ballooned four times since 2000 and now manages over $2 trillion in assets, an astounding figure. This is where the laws of diminishing returns would probably kick in—too much cash chasing too few strategies, which means taking investment bets that lack the real ‘edge’. Simon Lack, a hedge fund critic, was found quoting in The Economist saying, “At $1 trillion of assets under management hedge funds delivered acceptable returns. Less so at $2 trillion.”

The inability to have an ‘edge’ over others, especially old-fashioned retail stock pickers, has endangered the very existence of hedge funds. According to Bloomberg Markets, 635 hedge funds shut shop last year due to poor returns and mass redemptions, 8.5% more than in 2011.

Another impediment to generating high returns is high fees with the added pressure to outperform the markets year after year. In fact, a study had shown that the smartest investors are the ones who invest in low-cost funds. We had written this in our 7 February issue of Moneylife in our Earning Curve section (this issue is currently on stands).

This doesn’t mean that every hedge fund is endangered. Indeed, there are a few who spot the gaps in the market and exploit it exceedingly well. For instance, last year, Dan Loeb’s Third Point Ultra Fund generated 33.6% returns after fees. And there’s Steve Cohen’s SAC which made 12% returns (still this is below the S&P 500 index) although Cohen is suspected to have benefited from insider trading. However, such funds are few and far between and spotting winning hedge fund managers beforehand is almost impossible.

Read our review of The Quest for Alpha which pulls together various studies to show how hedge funds, venture capital, private equity etc. by and large generate sub-par returns, after adjusting for risks.

So what should the retail investor do? According to The Economist, a simple investment portfolio—60% in shares and the rest in sovereign bonds—has delivered returns of more than 90% over the past decade, compared with a meagre 17% after fees for hedge funds. In other words, a simple portfolio consisting of diversified equities should do the trick. If not, at least investing in diversified equity mutual funds over the long-term is also a time-tested strategy. Or you could simply invest in an index fund, SIP method and relax.

Here are some useful links that we have written about investing the sensible way.

15 stocks with high dividend yield

SIP smartly


UTI RGESS: A low cost option

UTI Mutual Fund plans to launch cost-effective index schemes based on the S&P Nifty Index and that will be eligible under the Rajiv Gandhi Equity Saving Scheme, 2012

UTI Mutual Fund recently filed offer documents with the Securities and Exchange Board of India to launch an open-ended as well as a close-ended ended index scheme—UTI RGESS. As these are index schemes, the expense ratio is capped at 1.70% (excluding the additional expense ratio depending on the inflow from the beyond 15 cities). As many as seven mutual fund companies that have filed offer documents to launch schemes that qualify under the government notified Rajiv Gandhi Equity Saving Scheme (RGESS). These schemes are targeted at first-time investors to encourage them to invest in equities by providing them a tax rebate for their investment. However, as Moneylife had recently pointed out that though investing through these schemes give investors the benefit of diversification and professional fund management, the costs associated with these schemes can go as high as 3% per annum. (Read: RGESS mutual fund schemes: High costs could erode returns)

The schemes from UTI Mutual Fund would invest 95%-100% of the portfolio in stocks of companies comprising the S&P CNX Nifty Index in the same weightage as in the index. The close-ended scheme would have a tenure of three years from the date of allotment. In the open-ended scheme, investors would have to complete the mandatory lock-in period of three years as specified under RGESS, post which they can choose to redeem or switch their investment if they do not wish to continue.

Actively managed schemes have delivered better returns than the index in the past. But choosing the right scheme is equally important. However, when in doubt, index schemes would be a preferred option. This would specifically be the case when choosing the right equity scheme for RGESS as eligible actively managed schemes would not have a long-term track record in order to judge their performance. Of course one could choose schemes of fund houses which have had an excellent track record of managing equity schemes but one has to keep an eye out on costs, as well. Would a fund manager be able to provide superior return post costs and justify the additional expense ratio of 1%?

Index schemes are expected to deliver returns that are close to those of the index. As the fund manager does not have to put in much effort, the cost structure of these schemes is lower than that of actively-managed schemes. The cost for index schemes goes up to 1.70%; for other equity schemes, the costs are capped at 2.70% (excluding the additional expense ratio depending on the inflow from the beyond 15 cities).

UTI Mutual Fund has a long history of managing equity schemes. Under the passive investing category it has just one index scheme—UTI Nifty Fund—based on the S&P Index. The scheme which was lunched in February 2000 has a corpus of Rs186 crore and an expense ratio of 1.50%. The scheme has a reasonably low tracking error over the last few years. Over the last one year and five years the scheme delivered a return of 19.42% and 7.41%. The S&P Nifty delivered a return of 19.92% and 7.40% over the same periods, respectively. However, the returns you are able to derive depend a lot on how and when you invest. The UTI  Nifty Fund is managed by Kaushik Basu who has an experience of over 25 years in the industry. He would also be managing the new UTI RGESS fund.


BSE Sensex, Nifty waiting for fresh cues: Wednesday Closing Report

A sharp fall below 6,020 will push the Nifty towards 5,950 while a close above 6,100 will mean a continuation of the creeping bull market

The benchmarks managed to retain their psychological levels of 20,000 on the Sensex and 6,000 on the Nifty amid highly choppy trade, a day ahead of the expiry of the near-month F&O contract. A sharp fall below 6,020 will push the Nifty towards 5,950 while a close above 6,100 will mean a continuation of the creeping bull market. The National Stock Exchange (NSE) recorded a volume of 68.59 crore shares and advance-decline ratio of 584:932.


The domestic market opened higher tracking the firm Asian markets in morning trade on signs of global economic growth picking up. US markets closed mostly higher on Tuesday on better-than-expected earning reports. The Indian market is expected to remain volatile ahead of the expiry of the January F&O contract on Thursday.


The Nifty started off 15 points higher at 6,065 and the Sensex resumed trade 24 points up at 20,015. Early buying in oil & gas, realty, consumer durables and metals lifted the market to its high in the first hour. At the intraday high, the Nifty rose to 6,072 and the Sensex stood at 20,073.


However, profit booking at higher levels saw the indices paring part of their gains in subsequent trade. The benchmarks entered the negative terrain in noon trade as selling intensified amid choppy trade. The decline led the indices to their lows wherein the Nifty fell to 6,044 and the Sensex retracted to 19,965.


The market continued to move sideways, fluctuating between the red and green in the absence of any positive triggers and the key European markets opening flat. But buying in realty, consumer durables, oil & gas and banking stocks helped the market pick some momentum in late trade.


The market closed marginally in the green with the Nifty adding six points (0.10%) to 6,056 and the Sensex rising 14 points (0.07%) to settle at 20,005.


While the Sensex managed to close in the green, the broader indices were not so lucky. The BSE Mid-cap index shed 0.03% and the BSE Small-cap index fell 0.21%.


The top sectoral gainers were BSE Realty (up 1.39%); BSE Consumer Durables (up 1.24%); BSE Oil & Gas (up 1.06%); BSE Bankex and BSE Healthcare (up 0.36% each). The main losers were BSE Capital Goods (down 1.24%); BSE Power (down 0.68%); BSE Auto (down 0.49%); BSE TECk (down 0.18%) and BSE PSU (down 0.07%).


Twelve of the 30 stocks on the Sensex closed in the positive. The chief gainers were Cipla (up 2.69%); Hindustan Unilever (up 1.97%); Reliance Industries (up 1.87%); Tata Steel (up 1.75%) and Wipro (up 1.72%). The key losers were GAIL India (down 3.35%); Tata Power (down 2.73%); Larsen & Toubro (down 1.92%); Jindal Steel & Power (down 1.61%) and Tata Motors (down 1.53%).


The top two A Group gainers on the BSE were—National Aluminium Company (up 8.12%) and Pidilite Industries (up 5.80%).

The top two A Group losers on the BSE were—HDIL (down 5.35%) and Gujarat Fluorochemicals (down 3.49%).


The top two B Group gainers on the BSE were—SEL Manufacturing Company (up 16.67%) and Uttam Galva (up 15.90%).

The top two B Group losers on the BSE were—WPIL (down 20%) and Shiv Vani Oil & Gas Exploration Services (down 14.11%).


Out of the 50 stocks listed on the Nifty, 23stocks settled in the positive. The major gainers were DLF (up 3%); Cipla (up 2.41%); ACC (up 2.31%); Sesa Goa (up 2.26%) and Ambuja Cement (up 2.26%). The chief losers were GAIL India (down 3.29%); Punjab National Bank (down 3.03%); Tata Power (down 2.96%); L&T (down 2.17%) and Jindal Steel & Power (down 1.96%).


Markets in Asia settled mostly higher on optimism from corporates on earnings for the December quarter. Hopes of the US Federal Reserve announcing fresh initiatives to spur growth, at the end of its policy meeting later in the day also boosted investor sentiment.


The Shanghai Composite advanced 1%; the Hang Seng gained 0.71%; the Jakarta Composite rose 0.31%; the Nikkei 225 jumped 2.285; the Straits Times climbed 0.80%; the Seoul Composite rose 0.43% and the Taiwan Weighted settled 0.40% higher. Bucking the trend, the KLSE Composite declined 0.59%.


At the time of writing, the key European indices were mostly lower and the US stock futures were mixed.


Back home, foreign institutional investors were net buyers of equities aggregating Rs899.83 crore on Tuesday while domestic institutional investors were net sellers of shares amounting to Rs938.70 crore.


Suzlon Energy today said it has bagged an order from Orange Renewable Power for setting up a 50.4 MW wind power project in Rajasthan. The company would supply 24 units of wind turbine generators for the project in Jaisalmer, which is scheduled to be completed in financial year 2012-13.The stock gained 0.95% to close at Rs21.25 on the NSE.


Looking to expand its business and grow its financial metrics going forward, new-generation private sector banking major Yes Bank has said it is open to possible acquisitions in banking, broking and asset management businesses, even as its organic growth plans are sufficient to meet its near-term targets. The stock climbed 1.97% to close at Rs521.50 on the NSE.


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