Name: Are hedge funds the true smart money?
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Are hedge funds the true smart money?

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Print articleJul 2, 2020 – 10.25amLog in&nbsp;or&nbsp;&nbsp;to save articleThis week, a turbulent to an end.And for asset managers it marks the time when they calculate just how much clients will pay them in performance fees for the wealth they created, or did not destroy, relative to benchmark.This has been a particularly crazy year as the pandemic-induced market volatility proved too hot to handle for some.And the suits of the investment management industry have been under siege from a that .That has triggered a fierce debate about who actually is the so-called smart money.Such is the insanity of this market that we're no longer turning to investment titans for guidance but a bored sports-betting tipster picking stocks out of a Scrabble bag.AdvertisementWhile the transparency of 'Davey Day Trader' Dave Portnoy's investment process should be commended, it’s a stretch to call it smart money.For decades, the hedge fund industry has laid claim to the title of the smart money.The funds deploy a variety of complex strategies that they claim deliver better risk-adjusted returns and to access their skill they charge premium management and performance fees. At present, those fees are on average 1.4 per cent and 16.40 per cent respectively.But are they worth it? The official numbers are ambiguous at best. The latest data from Chicago-based Hedge Fund Research shows its composite index of funds returned -5.08 per cent to the end of May. That is worse than the S&amp;P500 total return of -4.97 per cent.Meanwhile, a record 305 hedge funds were liquidated in the first quarter of 2020.There have been some in the hedge fund world and although the message is that they in a time of crisis, that is not obvious from the available performance data.AdvertisementBut it turns out hedge funds may actually be the smart money after all.A UBS quantitative research piece published in late February concluded that hedge funds did indeed have an edge in sharemarkets.The study examined ownership data or 13-F quarterly asset management disclosures of active mutual funds and hedge funds – which have consistently owned 35 per cent and 5 per cent of the United States sharemarket over the past decade.The study determined that roughly a third of US sharemarket returns could be explained by beta (the general direction of the market) factors, a third by factors such as quality, growth and momentum, and a third by idiosyncratic, or stock-specific factors.The study then examined relative ownership of indices and factors to determine the stocks that mutual funds and hedge funds either invested in or shunned.AdvertisementFor instance, if a certain stock had a 1 per cent index weight and applying a value factor suggested a 1.5 per cent weight and hedge funds owned 2 per cent, that implied hedge funds had an idiosyncratic overweight of 0.5 per cent.Mutual fund returns, the study found, tended to track returns from well identified factors such as quality and value. This is because the idiosyncratic factors are diversified away in aggregate.But the stocks hedge funds preferred did outperform these quantitative strategies.Hedge funds tend to gravitate towards stocks that have poor return characteristics such as small, low-quality or highly volatile stocks. But this is where they found their excess return.Some sectors of the market, such as healthcare and consumer discretionary, are driven by more stock-specific factors and hedge funds were able to outperform.Real estate was an anomaly as hedge funds delivered outperformance even though stock returns tended to a function of broader factors.AdvertisementThe findings do provide compelling evidence that hedge funds are the smart money. But the catch is they’re probably not the hedge funds you or your superannuation fund can invest in.There is a large and secretive world of privately managed hedge funds or those that are closed for new business that simply don't need to report their numbers to anyone other than themselves or their investors.These funds therefore aren't captured in the surveys and indices, but they do leave fingerprints in the stock ownership and 13F data.The survey, which was based on US stocks, also highlights an often overlooked aspect of the active versus passive debate – that is the artificial constraints placed on stock pickers.The paper's lead author, Paul Winter, explained that since most mutual funds are subject to tracking-error limits, their "views shrink" limiting their ability to deliver returns that are materiality better than systematic stock picking.But if a true hedge fund or personal investor finds a stock they like, the only constraint is the degree of conviction and how much money they have available.So perhaps active management is alive and well and humans can pick stocks after all. The challenge is getting these geniuses to manage your money.Log in&nbsp;or&nbsp;&nbsp;to save articleFollow the topics, people and companies that matter to you.AdvertisementFetching latest articles

Print articleJul 2, 2020 – 10.25amLog in&nbsp;or&nbsp;&nbsp;to save articleThis week, a turbulent to an end.And for asset managers it marks the time when they calculate just how much clients will pay them in performance fees for the wealth they created, or did not destroy, relative to benchmark.This has been a particularly crazy year as the pandemic-induced market volatility proved too hot to handle for some.And the suits of the investment management industry have been under siege from a that .That has triggered a fierce debate about who actually is the so-called smart money.Such is the...

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Jonathan Shapiro

For 70 years, The Australian Financial Review has been the authority on business, finance and political news in Australia.

Are hedge funds the true smart money?

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