JANUARY 28, 2016
One of the most controversial questions in the investment world is: why do hedge funds keep gaining assets when their performance over the past decade has been relatively poor compared to stocks? After all, hedge fund returns have lagged the S&P for the past 7 years; a period that covers a full business cycle. One way they have accomplished this feat is by changing the definition of “performance” over time to overcome the inability to live up to the preceding definition. Thus, high return was replaced by downside protection, alpha and, most recently, diversification and risk reduction. Hedge funds have faced a number of challenges over the past three decades that have led fundamental changes their objectives and operations. A short list of these challenges includes the proliferation of hedge funds and hedge fund strategies; the institutionalization of hedge fund investors; economic crises in 1987, 1994, 1998, 2001 and 2008; and increased criticism of hedge fund performance and fees. As with any evolution, some hedge funds thrived -- at least in terms of increasing assets under management and generating income for their managers --while others either became extinct or are an endangered species. In the course of this evolution, the surviving hedge funds would not be recognized by those of 20 years ago. The performance criteria
FEBRUARY 1, 2016
While hedge fund fees have declined during the past several years, they are still remarkable for the fact that they have only come down marginally over a 30-year time period and that they are higher than almost any other fees charged for money management. How can we explain this phenomena? Taking a look at hedge funds as an industry and applying some of the principals of microeconomics may shed some light. According to the theory of the firm, in a competitive industry competition among participants will drive prices down, especially where new entrants can enter relatively easily.
The hedge fund world has over 10,000 hedge funds and hundreds of new ones start every year. This seems to be the model of a competitive industry, where one would expect continual downward pressure on fees. The explanation for this stickiness in fees are different for large, established hedge funds and for relatively new and smaller hedge funds. Larger more established hedge funds are very much in demand in the present economic milieu. As in other industries, well established brand names attract buyers (hedge fund investors). Although hedge funds are not allowed to overtly advertise, there are effective and long established distribution channels by which hedge funds become known to potential investors, including third party marketing, hedge fund databases, capital introduction sessions, industry publications, industry conferences, wealth management groups, brokers, banks, investment advisors and investment consultants. Adding to the upward pressure on fees
FEBRUARY 5, 2016
When CALPERS, the country’s largest pension plan, decided to liquidate its hedge fund portfolio in 2014, there was an outpouring of predictions of a mass exodus of pension plans’ investments in hedge funds. The mass exit never occurred. In fact, pension plans continued to throw money at hedge funds at an increasing rate. As a result, most observers predict a continued growth of pension fund investments in hedge funds. However, this may be an overly sanguine view which fails to take into account the slow decision making process of institutional investors in general and pension plans in particular. It took CalPERS over a year of intensive analysis to come to its decision, which it attributed to administrative cost and marginal contribution of hedge funds to their overall portfolio rather than lack of performance. What may be more significant in determining the future of pension fund investment in hedge funds are
FEBRUARY 16, 2016
The Narrative Audit ™ We all love a good story. Since we were infants, stories have been important in teaching us about the world. It turns out that we remember things more easily if they are in the form of a story or narrative than rather than as unconnected fragments of information. There seems to be a hardwired need that we have for imposing order and causality to both historical and future events. The Narrative Fallacy has been singled out as a key element of behavioral finance to mean that we connect elements that may or may not have a real connection. In the world of finance, narratives run rampant. Every product is sold using a story. Analysis and forecasters product narrative forecasts and analyses by the thousands as do companies in statements and annual reports. You rarely see a newsletter that states “the Dow will reach 2,000 in a year” without a long accompanying narrative to justify the forecast. Unfortunately, narratives often serve to distract us from
SEPTEMBER 21, 2014
Post Madoff due diligence has taken on an increased importance, and new techniques are needed to identify financial frauds. This article describes several quantitative methods that can be used to identify potential frauds, including Benford's law, performance drivers and strategy replication and statistical significance tests. An extensive analysis of the Madoff Ponzi scheme describes the red and green flags that enabled the fraud to remain undetected for 20 years. Finally, The article explores the role of behavioral heuristics and fallacies that often enable fraudsters to succeed. These include representativeness, anchoring, overconfidence, loss aversion, regret aversion, confirmation bias and selective perception. Furthermore, an automatic trust mechanism that allows us to live in society may also help fraudsters in their ploys. Finding Financial Fraudsters
OCTOBER 19, 2015
As is well known, the performance of hedge funds and liquid alternative investments (whose performance track that of hedge funds) has been abysmal, producing negative alpha (i.e., lagging the performance of the S&P 500) while maintaining the high fees and performance share. Despite this performance, funds continue to flow into hedge funds, especially from institutional investors.
Justifying Hedge Fund Performance
A number of arguments have been put forward to explain (or justify) the poor performance of hedge funds. One such is the argument that the S&P is not a relevant benchmark for evaluating hedge funds because the latter's goal it precisely not to track the S&P. Rather, hedge funds seek to reap absolute