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  1. It seems that all we read today about hedge funds is about how they, as a group, are failing and investors are heading for the exits. In this Bloomberg article, I discuss how the current dialogue is an overreaction, even though many criticisms are valid, and is based on a false comparison. We’ve long been saying that, as a whole, most hedge funds are too correlated with equity markets and too expensive given that too much of their return comes simply from equity markets rising, something that isn’t bad but is available for nearly no fee. I haven’t changed my views, and also believe that hedge funds set expectations too high, especially for the tough times that inevitably occur from time to time. But what we hear today is an overblown case against hedge funds based on bad math rather than facts and sound reasoning.

  2. After my last piece on hedge funds I’ve gotten a lot of questions that often come down to the issue of “beta” versus “correlation” with the market and, more generally, about “alpha.”  I thought I’d share a version of my typical response.

    First, in response to many otherwise good questions that I think confuse correlation with beta, they are not the same. As an example — for a fund that is 10% long stocks and 90% cash, the beta of the fund is 0.1, but the correlation to stocks is 1.0 as stocks drive all the variability (in excess returns). Similarly, a fund that is 40% long stocks and 60% cash has a beta of 0.4, but that fund still has a 1.0 correlation to stocks. Beta measures how much, on average, a fund responds to stock market moves, correlation measures how “tight” that response is. To go the other way from the prior examples you could have a beta of 0.4 with stocks, perhaps being net long 40% stocks, but with massive additional offsetting long and short positions that don’t change your beta (as they are offsetting!) but make it so that your 0.4 beta doesn’t tell you very much about your subsequent returns (i.e., a low correlation).

    Now, for a real world example; hedge funds are generally net long about 40% of the stock market.  As a result, they usually have a beta of about 0.4.  The rest is not in cash, as in my example above, but instead hedge funds attempt to do “other things.”  Say those other things are taking long and short positions that balance such that they have no direct equity market exposure.  This does not change the fund’s beta of 0.4, but can impact the fund’s correlation to stocks.  If they do a lot of these other things their correlation with the stock market is lower than if they do little of these other things.  Either way, their beta remains 0.4 and comparing them to 40% of the stock market makes sense as that represents their exposure to the market. Ideally, in my view, hedge funds should just do the other things and have no market exposure, a 0.0 beta, but whether at 0.0 or 0.4 beta they will look relatively worse than the stock market during big bull runs. Again, that's not the point — any diversification from an ex post bull market tends to look bad. 

    Ultimately, it is these other things that really matter, as you can think of the hedge fund above as being the market plus another source of return uncorrelated to the market. If that other source of return also reliably produced positive returns over time, it would qualify for the (overused term) "alpha."  It is these other things, delivering alpha, for which you should (perhaps!) pay hedge fund fees, not for the beta.[1] One of the criticisms I think legitimate is that hedge funds are doing less of these other things nowadays and so this alpha (both attempted and realized) has been smaller making correlations (but not beta) go up, as if you do fewer other things but stay the same 40% net long the market now explains more of your variability, and the value proposition in hedge funds is probably worse now (I show that here). 

    I hope this helps! Alternatively, at the least, I hope I haven’t made it worse.

    Cliff




    [1] An additional subtlety is whether these other things are truly unique “alpha” or rather straightforward known strategies. I’ll leave that to revisit (yet again) another day.




    [1] An additional subtlety is whether these other things are truly unique “alpha” or rather straightforward known strategies. I’ll leave that to revisit (yet again) another day.





  3. Many of the current articles that are critical of hedge funds may be giving good advice, but for the wrong reasons.

  4. CalPERS made big news today announcing it will end its investments in hedge funds. AQR has long researched and commented on the hedge fund industry and here we reference that body of work to put CalPERS's decision into context.

  5. Miles Johnson of the FT takes strong issue with an article I didn’t write but, rather, one he thinks someone like me would write (I’m sorry if that’s hard to follow but it’s Miles’s fault).

    I wrote a fairly narrow piece pointing out that articles marveling at the 2015 compensation of the top 25 hedge fund managers (e.g., here or here) are about wealth when they purport to be about income. That’s basically it.  Not a statement that wealth wasn’t important.  Not a defense of this wealth.  Ayn Rand didn’t leave the building as she never entered it.  I mentioned that this “mistake” likely occurs as higher numbers sell more papers (or whatever people buy or read for free these days) than do lower numbers. I made a point of saying that this is not about the inequality debate, rather, it’s just about exaggeration and imprecision. That was it. 

    In fact, in the email I sent when recirculating this article I wrote a year ago (sorry you missed it the first time Miles) I specifically said and meant, “There’s plenty to debate on the investing merits and the inequality issues here without simply bad, and intentionally misleading, math.” 

    Nowhere in my original piece, or anywhere else, is my obtuse denial of these important issues actually detectable. Nowhere did I say that wealth wasn’t an important part of the debate.  Nowhere did I defend the hedge fund business model (quite the opposite, more on that below).  I pointed out, literally just this — that wealth is not income, and that these now annual articles confuse this, probably intentionally. I stand by that as fact. 

    Actually, I have written a lot criticizing hedge funds and I’ve done it for a long time. My firm isn’t really a hedge fund by fees or majority of assets, but that is apparently too subtle for Miles (or inconveniently didn’t fit his slant) as labels are so much easier.  I actually say as a matter of disclosure here that my firm has likely benefited from the move to lower fees and truly hedged products and away from the traditional hedge fund model and that I have a long history of criticizing overpriced and under-hedged hedge funds.  In the age of Google it would not take an incredible effort of journalistic research to note my analysis and commentary going back to 2001 in hereherehere, or maybe here?   I got yelled at by many in the hedge fund industry for it (especially the first one when I was younger and would actually listen to semi-famous people yelling at me on the phone!).  The hedgies didn’t want balance and accurate analysis back then any more than Miles does now.

    I also wonder if Miles has such harsh words for other critics of the misrepresented top 25 managers’ earnings lists like Matt Levine at Bloomberg View. I’m guessing no as despite Matt and I repeatedly overlapping on this issue Johnson couldn’t misrepresent Matt’s career, history, and motivations in order to write the political screed Miles clearly wanted to pen.

    Miles, some advice. Click on a few hyper-links and actually read the background pieces. Try to understand the (admittedly narrow in my original piece) point of what you read, not the point you think the person might be making based on who they are.

    I 100% stand by the piece Miles criticizes and find his criticisms to be based entirely on a non-existent essay he thinks people like me would write.  Finally, I’m proud of my long history of balance and willingness to criticize and advocate for change in the hedge fund industry.

     

  6. The New York Times has gotten in on Institutional Investor’s annual listing of the top hedge fund earners. The reasons for this include standard gawking at the rich that has probably been going on since one person had a bigger mud hut than her neighbor, but also the scoring of certain political points. Unfortunately, this list, published for many years now, makes little sense.



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