FT Alphaville gives us this rather interesting number:
But here’s the thing that we don’t think many people have noticed yet: since the start of 2009 the US stock market has returned eight times as much as the average hedge fund.
They then give us much the same idea in a different set of numbers:
If an investor put 60 per cent of their money into a Vanguard index fund tracking the S&P 500, the the other 40 per cent into its
Total Bond Market Index fund, and re-balanced it once a year, they made 7.4 per cent a year over the last decade. The average hedge fund made 5.8 per cent, on HFR numbers.
Seriously? Simple index trackers beating hedge funds with their masses of highly trained brains busting a gut to make money on our behalf? Can these numbers really be true?
Yes, they most certainly can and Adam Smith knew why all the way back in 1776.
To give his argument shorn of that 18th century prose. There's an average return to investing: clearly and obviously there is, because we can average the return across all different types of investing, it's a mathematical truism that we can do this and that there is this average. So, imagine what happens when some very bright, motivated and well paid people find a method of continually getting better returns than this average?
It doesn't matter what they're doing to beat this average either. They could be running a hedge fund trading low beta stocks, making smartphones like
We can also safely assume that other investors would like to get themselves some of those above average returns. That's what most investors are trying to do of course, beat that market (that market being that average). So, what happens now? More capital flows into those areas where people are gaining better than average returns. The low beta stocks rise in value meaning that the new investors are no longer making outsized returns. Samsung starts making smart phones and Apple's dominance of the market shrinks. The odds on that third runner at Kempton shorten and it's no longer an outsized return for the risk being taken (for we can indeed become more sophisticated in our model and look at risk adjusted returns if we'd like to).
The end result of this will be that those formerly excess returns have been competed down to being just the normal average returns again. Or, as often happens, the lemming like rush to get those excess profits has led to returns falling below the average. This is simply an inevitable partner to our having free markets. When excess profit opportunities are identified they get competed away.
Adam Smith thought this was just great of course, as do I. For we want people to identify excess profit opportunities: these are the low hanging fruits of inefficiency in our capital allocation as a society. And we also want those fruits, once identified, to be plucked, or competed away. So that we have a more efficient allocation of capital and we can all go off and look for the next excess profits opportunity.
Now I wouldn't say that this is absolutely true of every hedge fund out there. It's only that we can observe that it is true of the current universe of hedge funds on average. Or alternatively, that we might have enough capital (possibly even too much) in hedge funds. They used to provide excess profits, enough capital has flooded into them that they do so no more and now, as an exciting investment class, they're done.
Or as a commenter at Alphaville put it:
End of day the original sell of Hedge Funds was "alpha".
Alpha is market outperformance. When your sector is miniscule that's a plausible boast. When your sector makes up a significant part of the whole market, it is conceptually impossible.
That's very much the same thing I'm saying.
