DFA International Equity Performance Since Inception

The Dimensional Fund Advisors International Core (DFA295) and International Vector (DFA227) equity funds offer exposure to the global equity markets, including emerging markets, excluding the US and Canada. As with all DFA equity funds, these products offer an increased exposure to small cap and value stocks relative to the market, with the Vector product having the most pronounced small cap and value tilts. These funds also have higher fees than comparable market-cap weighted index funds: DFA295 has an MER of 0.49% and DFA227 has an MER of 0.61% compared to a weighted average MER of 0.27% for an 87%/13% mix of XEF and XEC. Fees tend to be one of the best predictors of future performance, but with Dimensional’s tilts toward small and value stocks, and their careful implementation, we might expect slightly better long-term performance.

DFA vs. Index ETFs

Index returns cannot be captured by investors, so we will compare the DFA returns to live ETFs with their own fees and implementation costs.  There is insufficient data for XEF and XEF, which are Canadian listed, for a since inception comparison. We have instead constructed a hypothetical ETF portfolio consisting of 87% EFA and 13% EEM until October 2012, 87% IEFA and 13% IEMG from November 2012 through April 2013, finally switching to 87% XEF and 13% XEC through June 2018. In a live portfolio an investor would be unlikely to switch ETFs with this frequency due to tax implications and transaction costs. This has been ignored for the comparison. It is also worth noting that IEFA, IEMG, XEF, and XEC offer some small cap exposure, while EFA, EEM only offer large and mid cap exposure.

  • For the ETF comparison we use EFA + EEM / IEFA + IEMG / XEF + XEC

DFA295 Index ETFs Difference
1-Year Total Return (%) 9.24 8.95 +0.29
3-Year Annualized Return (%) 7.83 7.37 +0.46
5-Year Annualized Return (%) 11.89 11.40 +0.49
10-Year Annualized Return (%) 6.00 5.60 +0.40
Since Inception (07/2005) (%) 5.97 6.03 -0.06

Data Sources: iShares, MSCI, Morningstar Direct, Dimensional Returns Web

DFA227 Index ETFs Difference
1-Year Total Return (%) 9.37 8.95 +0.42
3-Year Annualized Return (%) 7.95 7.37 +0.58
5-Year Annualized Return (%) 11.94 11.40 +0.54
10-Year Annualized Return (%) 5.63 5.60 +0.03
Since Inception (07/2005) (%) 6.68 6.83 -0.15

Data Sources: iShares, MSCI, Morningstar Direct, Dimensional Returns Web

DFA295 and DFA227 have managed to outperform index tracking ETFs after fees for the trailing 10-year period. This is no small feat. Some credit must go to DFA for implementation of these strategies, but most of the credit goes to the fact that International small and value stocks have delivered excess performance. Both funds have trailed since inception. This is again driven by the weaker performance of International small and value stocks at the beginning of the funds’ lives.

Tax Considerations

Holding EEM, EFA, IEFA, and IEMG would result in one level of unrecoverable withholding tax from the foreign countries for a Canadian taxable investor. DFA holds securities directly, meaning that the taxes withheld by foreign countries could be could be recovered. Today this is somewhat less of an issue for an ETF investor as XEF holds securities directly. However, XEC continues to hold the US listed IEMG resulting in one level of unrecoverable withholding tax. On after-tax basis we would expect this to further improve the performance of DFA over a comparable International equity ETF allocation.

Should you be Trend Following with Managed Futures?

The holy grail of investing is finding assets that are imperfectly correlated with each other. Adding assets that behave differently together in a portfolio improves the expected outcome. A reduction in volatility has obvious behavioural benefits, but it can also increase long-term wealth creation by smoothing returns.

There is little question that stocks and bonds belong in a portfolio. There is also substantial credible research demonstrating that adding exposure to certain factors – quantitative characteristics of stocks and bonds – increases portfolio diversification and expected returns. While many factors such as size, value, and profitability are relatively well-known, there are others that are discussed less frequently: trend following is one of those factors.

Trend following strategies are implemented with managed futures. Managed futures attempt to capture a factor known as time-series momentum, or trend momentum. This factor consists of long exposure to assets with recent positive returns and short exposure to assets with recent negative returns. The strategy is agnostic to the type of assets, meaning that it can be implemented with equities, fixed income, commodities and currencies.

Managed futures have historically proven to have strong returns, low correlation with stocks and bonds, and low volatility in general. Notably, the Credit Suisse Managed Futures Liquid Index returned 23.05% in USD in calendar year 2008 while the Russell 3000 – an index of US stocks – returned negative 37.31%.

This was not the first time that managed futures offered strong returns in bad markets. In a 2017 paper from AQR titled A Century of Evidence on Trend-Following Investing, the authors found that the performance of this strategy has been very consistent, including through the Great Depression and other substantially negative market events. Beyond the returns being strong, the asset class has maintained nearly no correlation with stocks or bonds, providing a substantial diversification benefit over time.

Research Criteria

We do not consider implementing an investment product unless it is backed by great research. To meet that criteria, the research must show that a strategy is persistent, pervasive, robust, sensible, and investable. The research on managed futures does check many of these boxes – it is persistent, pervasive, and robust. The biggest questions are whether or not there is a sensible explanation for managed futures to outperform going forward, and is it investable?

Sensible

Small cap and value stocks are riskier assets and therefore it is sensible that they would have persistent higher expected returns. The explanation for managed futures’ outperformance is harder to grasp. From the AQR paper:

The most likely candidates to explain why markets have tended to trend more often than not include investors’ behavioral biases, market frictions, hedging demands, and market interventions by central banks and governments. Such market interventions and hedging programs are still prevalent, and investors are likely to continue to suffer from the same behavioral biases that have influenced price behavior over the past century, setting the stage for trend-following investing going forward.

This is a bit of a stretch as far as expectations for the future go. Betting on persistent risk premiums makes sense. Betting on persistent behavioural biases and market interventions is not something that I am comfortable with. Is it reasonable to bet on behaviour persisting? Human behaviour can change, especially when we have knowledge about our past behaviour. Behavioural errors are notably different than risk premiums.

Investable?

To be investable a strategy has to be cost effective and tax efficient to implement. We can look to a real-world example to examine how investable the managed futures strategy is.

In Canada, Horizons launched the Auspice Managed Futures Index ETF (HMF) in 2012. It closed in 2018 due to a lack of assets. A managed futures index is quite different from a typical low-turnover total market cap weighted index; managed futures indexes use a pre-defined quantitative methodology to follow the managed futures strategy. Similar to any momentum-based strategy, managed futures have an inherently high turnover.

HMF had a management expense ratio of a little over 1%, but it also had a substantial trading expense ratio in each year of operation due to the high turnover of the strategy. The TER is a real cost that reduces returns and must be considered.

Horizons Auspice Managed Futures Index ETF TER

2012 2013 2014 2015 2016
0.68% 0.68% 1.56% 1.39% 0.69%

Data Source: Horizons' HMF MRFP

As a point of reference, the Dimensional Fund Advisors US Vector Equity fund, which is a US total market fund with a heavy tilt toward small cap and value stocks, typically has a TER of 0.01%. This is not an apples to apples comparison as the two strategies are vastly different, but you see the difference in implementation costs between a small cap value strategy and a managed futures strategy.

The total costs of implementing this strategy are high, exceeding 2% in some years. These costs could be justified with a sensible reason to continue expecting substantial outperformance, but I believe that aspect of this strategy is too uncertain to bank on.

High turnover leads to tax inefficiency. Much like expenses, taxes lower investor returns. A managed futures fund could be held in a tax-preferred account to mitigate this issue, but the tax inefficiency is another drawback to contend with.

Does It Belong in a Portfolio?

I cannot argue with the fact that managed futures look excellent in a back test, and there are a lot of people much smarter than me selling managed futures products based on these back tests. Without a sensible risk-based explanation, the high costs and tax inefficiency of this strategy will keep me away for now.

Cash Flow ≠ Wealth

There is more to being wealthy than having a high income.

Cash flow can come and go. Ben Carlson recently had a post citing research from Thomas Hirschl at Cornell. The research shows:

  • 50% of Americans will be in the 10% of income-earners for at least one year during their working lives.
  • 11%+ of Americans will be in the top 1% of income-earners for at least one year.
  • 94% of Americans who make it to the top 1% income status will maintain that position for only one year.
  • 99% of Americans who make it to the top 1% will lose their top 1% spot within a decade.

Johnny Depp might be the most current and extreme example of this; he has reportedly squandered $650M of earnings on a lavish lifestyle with nothing left to show for it.

Cash flow

Cash flow is not wealth. High spending during years of strong cash flow may afford the appearance of wealth, but when the cash flow is gone the lifestyle goes with it. Saving a portion of that cash flow can lead to a base of assets.

Assets

Growing a base of assets is by no means easy. It takes some combination of planning, discipline, and luck. The fortunate side effect is that anyone who has applied planning and discipline to build up their assets is likely to maintain their planning and discipline into the future.

Wealth

Without discipline, a large asset base can be easily spent. Based on this someone with substantial assets relative to their neighbour may not be wealthy. Wealth is assets relative to current and future expenses. This is where the intersection of assets and expenses becomes interesting.

Take a financially independent 45-year-old with an $8,000 per month lifestyle. They would need about $3.8M to be financially independent, and each additional dollar of desired lifestyle spending would require about $40 of additional assets. That magnifying effect works in both directions; the required assets to fund financial independence for a 45-year-old drops to $1.5M if they can manage to live on $3,000 per month.

Expenses

Expenses are the link between cash flow, assets, and wealth. If wealth is defined as independence and freedom, then low expenses can be one of the strongest drivers. Lower expenses lead to a higher savings rate while also reducing the amount of assets required for financial independence. It is easy to spend more by becoming accustomed to luxuries while effectively robbing your future self.

Spending wisely is an idea that has been popularized by Mr. Money Moustache, among other frugality bloggers:

When you wriggle yourself into the narrow nook of luxury, your perspective on the world, and your ability to survive and thrive in it, also constricts dramatically. Like any drug, it can be fun to indulge in occasionally. But to seek to constantly maximize luxury in all areas of your life to the limits of what you can afford? Pure insanity.

There is, of course, a balance between frugality and comfort. The takeaway is the true cost of expenses. If you have cash flow, high expenses reduce your ability to build assets. If you have assets, high expenses reduce the value of those assets relative to your lifestyle, making financial independence less attainable.

Wealth is relative. Not relative to other people, but relative to your own expenses.

Banning embedded commissions would not have fixed financial advice in Canada

There was a small uproar when the Canadian Securities Administrators decided that they would not move forward with banning embedded commissions. Rob Carrick commented:

The dream of creating a standard of transparent, client-focused service in the investment industry died Thursday.

It is certainly true that eliminating embedded commissions would have increased transparency and more closely aligned the interests of clients with those providing advice.

The problem that nobody is talking about is that most financial advisors are still convinced, despite the mountain of evidence to the contrary, that active management is necessary for their clients to be successful.

Eliminating embedded commissions would not change this view. I do not know if anything would. The industry perception seems to echo that of Fischer Black when he left MIT for Goldman Sachs:

The market appears a lot more efficient on the banks of the Charles River than it does on the banks of the Hudson.

In other words, the market looks a lot more efficient in the academic research than it does on the ground in practice. Fischer’s comment was lamenting the challenges of implementing his research, but in my experience most financial advisors have the same sentiment.

Those clueless academics pushing index funds have no idea what it’s like on the ground…

Those giving financial advice are subject to the same biases as individual investors, leading them to believe that they are able to provide market-beating advice. This usually leads to higher risks and costs to the client, and a relationship that is based on performance over financial advice. In the face of irrefutable evidence, the broad community of financial advisors in Canada is still intent on using active management in order to serve their clients in what they deem to be the best possible manner. From a recent survey:

In fact, 86% say the risks in the market add up to an environment that favours active management. These professionals demonstrate a clear preference for actively managed investments and continue to allocate the majority of assets to these strategies.

I am not the first person to suggest that a best interest standard would not solve the problem. A 2017 paper titled The Misguided Beliefs of Financial Advisors found that Advisors trade frequently, chase returns, prefer expensive, actively managed funds, and underdiversify their own personal investments, just as they do for their clients’. This indicates that the bad investment advice is not malicious, but misguided.

Financial advice is not at a point where there is consensus by practitioners on how evidence should be applied. There is academic consensus about the evidence, just not a willingness of practitioners to apply it. In a 2016 Freakonomics episode Vinay Prasad, MD, MPH, explained that there was a time not too long ago when medicine was practiced in a similar manner to the way that investment advice is given today.

The reality was that what we were practicing was something called eminence-based medicine. It was where the preponderance of medical practice was driven by really charismatic and thoughtful, probably, to some degree, leaders in medicine. And you know, medical practice was based on bits and scraps of evidence, anecdotes, bias, preconceived notions, and probably a lot psychological traps that we fall into. And largely from the time of Hippocrates and the Romans until maybe even the late Renaissance, medicine was unchanged. It was the same for 1,000 years. Then something remarkable happened which was the first use of controlled clinical trials in medicine.

In the world of financial advice, we are still in this phase, where evidence does not have the final say in the advice given to clients. This may take a long time to change. In the same Feakonomics episode, Iain Chalmers, a British health services researcher, explained:

There was a great deal of hostility to [evidence-based medicine] from, I’d say, the medical establishment. In fact, I remember a colleague of mine was going off to speak to a local meeting of the British Medical Association, who had basically summoned him to give an account of evidence-based medicine and what the hell did people who were statisticians and other non-doctors think they were doing messing around in territory which they shouldn’t be messing around in. He asked me before he drove off, “What should I tell them?” I said, “When patients start complaining about the objectives of evidence-based medicine, then one should take the criticism seriously. Up until then, assume that it’s basically vested interests playing their way out.” I would say it wasn’t actually until this century [that evidence-based medicine took hold]. So one way you can look at it is where there is death there is hope, as a cohort of doctors who rubbished it moved into retirement and then death, the opposition disappeared.

Until we reach a point of acceptance of evidence as the most sensible way to guide investors, a best interest standard is meaningless. If the medical profession is any guide it may be a generation or more before evidence-based financial advice becomes mainstream.

Does active management work for institutional investors?

It is increasingly well-understood that low-cost index funds will, on average, beat actively managed mutual funds for average investors. I think that there is still a perception that large institutions like pension funds and endowments, with access to the supposedly best money managers are able to outperform.

Fortunately there are some good sources of information that we can turn to to see if this is true.

It has been well documented that fees can vary substantially depending on who is investing. Retail investors typically pay much higher fees in terms of percentage of their assets than institutions. Institutions are also able to access asset classes, like real estate, private equity, and hedge funds, that might not be readily available to a retail investor. A proponent of active fund management might argue that these factors should be conducive to market beating performance for institutional investors.

A 2017 report from Standard and Poors looked at the net and gross of fee performance for institutional investment accounts with the intention of seeing if fees were the sole cause of underperformance for retail active managers. The data in the report show that the overwhelming majority of actively managed institutional accounts underperformed their benchmark over 10 years, before fees. The underperformance was only exacerbated after fees. Well that answers that. While it may help, the lower fees that institutional investors are able to negotiate do not mean that active management will work for them.

Every year, the National Association of College and University Business Officers (NACUBO) releases their report on the performance of college endowment funds. With people like the legendary David Swensen at the reins of the Yale endowment, endowment funds have often been looked to as thought leaders for the investment world. Taking advantage of their exceptionally long time horizons, endowment asset allocations will often allow for less liquid asset classes like private equity and hedge funds. These asset classes do also tend to be more expensive to invest in and require more staff on hand to manage. It’s all worth it if the returns are great.

The 2017 NACUBO report shows that the 10-year average return for all 809 institutions that they track has been 4.6%. A simple 60% stock and 40% bond index fund portfolio has returned a little more over the same period, for a tiny fraction of the costs and far less complexity. Endowments have not generated the stellar performance that we might expect.

In the great financial crisis, Harvard’s massive endowment was famously left with no cash to cover their margin calls, and had to go into debt to stay afloat. Much of their capital was tied up in illiquid private equity and real estate. They lost nearly 30% in 2009, about the same as a 60/40 index fund portfolio.

Some pension funds have gotten the message. Steve Edmundson, who manages the Nevada State pension fund, a 35 billion dollar fund nearly the same size as Harvard’s endowment, does nothing but invest in low-cost index funds. It’s also worth mentioning that the Nevada State Pension fund has consistently outperformed Harvard’s complex and expensive endowment fund.

In a 2013 report, the Maryland Public Policy Institute wrote that:

“State pension funds, including Maryland, have succumbed for years to a popular Wall Street sales pitch: “active money management beats the market.” as a result, almost all state pension funds use outside managers to select, buy and sell investments for the pension funds for a fee. the actual result — a typical Wall Street manager underperforms relative to passive indexing — is costly to both taxpayers and public sector employees.”

The report continues:

“Getting pension fund administrators to support the policy and to educate legislators about indexing will be an uphill battle. By agreeing to the policy, administrators essentially admit they made mistakes by betting heavily on active managers. Who wants to admit an error? Investment consultants and Wall Street money managers will vigorously oppose such a policy.”

With their ability to negotiate lower fees and gain exposure to more exotic asset classes, it might be expected that large institutional investors could beat the simple low-cost strategy of index investing. That data do not support this assertion. What we do know is that complexity increase costs, and costs decrease average returns. Even the largest and most sophisticated investors cannot escape this truth.

How much risk should you take?

Risk is more than an important part of investing. The whole concept of a financial market exists on the basis that taking risk can result in financial gain. If you do not take risk in financial markets, you expect very low returns. Of course, with risk also comes the potential for loss. Elroy Dimson of the London School of Economics said “Risk means more things can happen than will happen”.

In other words, risk means that there is a distribution of outcomes, and you will not know which outcome you actually get until it happens. As much as we like to think that we can understand risk, the possible distribution of outcomes is beyond our ability to comprehend.

While we are not able to control or predict the distribution of outcomes, we are able to choose the type and amount of risk that we take with our investments.

To start this discussion, I need to introduce two types of risk. The first type of risk is called idiosyncratic risk, which may also be referred to as company specific risk, or diversifiable risk. Idiosyncratic risk is not directly related to the market as a whole. Individual stocks will typically move to some extent with the market, but they may also fluctuate due to their specific circumstances. Think about Volkswagen’s share price plummeting after their emissions scandal.

There is no reason to expect a positive outcome for taking on idiosyncratic risk. It may work out in your favour, but it may result in substantial and unrecoverable losses. Idiosyncratic risk can be diversified away. Owning all of the stocks in the market eliminates the specific risks of each company. What is left is market risk.

Market risk is the risk of the market as a whole. It cannot be diversified away. For taking on the risk of the market, investors do expect a positive long-term return. When you invest in one stock, or one sector, you are getting exposure to both market risk and idiosyncratic risk, but the idiosyncratic risk can easily dominate the outcome. The most reliable long-term outcome would be expected when idiosyncratic is diversified away. Practically, this simply means owning a globally diversified portfolio of index funds, an idea that is not new to anyone who has been watching my videos.

Most investors do not own a 100% equity portfolio. Portfolios will typically consist of some mix between equity index funds and bond index funds. Long-term outcomes are uncertain, but we know that over the past 116 years stocks have outperformed bonds globally, while bonds have been less volatile. A portfolio becomes less risky and has a lower expected return as the allocation to bonds increases.

The decision about how much risk to take is driven by the ability, willingness, and need to take risk.

Equity market risk has tended to pay off over long periods of time, and the distribution of outcomes also tends to narrow. For example, over the 877 overlapping 15 year periods from 1928 to 2015, the US market outperformed risk-free t-bills 96% of the time. The ability to take risk is primarily driven by time horizon and human capital. We have been talking about risk as an unpredictable distribution of outcomes. A more tangible definition might be the probability of not meeting your goals.

For a young person with lots of remaining earning capacity, the market underperforming t-bills hardly affects their ability to meet their goals - in fact, it would be a good opportunity for them to buy cheap stocks. On the other hand, a near-retiree taking substantial losses in the years leading up to retirement would be devastating to their ability to meet their spending goals. In general, it is sensible to take less risk for goals with short time horizons and more risk for goals with longer time horizons.

Even with an unlimited ability to take risk, most investors are constrained by their own willingness to take risk. An investor may look at the history of market risk and decide that it is too volatile for their preferences. The MSCI All Country World Index was down 33% in Canadian dollars between March 2008 and February 2009.  That’s a pretty big drop. In his book Antifragile, Nassim Taleb introduced what he calls the Lucretius Problem: we tend to view the worst historical outcome as the worst possible outcome, but that is nowhere near the truth. If a 33% drop scares you, you would need to be comfortable with the potential for a far deeper decline to be confident investing in a 100% equity portfolio.

The need to take risk brings us back to goals. If someone wants to spend $5,000 per month adjusted for 2% average inflation for a 30-year retirement, they would need about $2.5 million dollars to be able to afford to take no risk. They could hold cash in savings deposits and deplete their assets over time without any volatility. Most people do not accumulate enough to fund a risk-free retirement, so they must introduce some level of risk to increase their expected returns..

The right amount of market risk in a portfolio is sufficient to hopefully meet the goal for the assets without introducing the potential for catastrophic failure due to large declines at the wrong time. There are rules of thumb out there, like having 100 minus your age in stocks, but they have little basis. Truly there is no optimal answer, but there is little debate that expected returns and expected volatility are highest with a 100% equity portfolio, and investors might add in bonds to match their ability, willingness, and need to take risk.

Do most financial advisors know what they're talking about?

Napoleon Bonaparte famously said "Never ascribe malice to that which is adequately explained by incompetence". This is a way of thinking known as Hanlon’s Razor, and it can help us interact with the world more favourably.

There is an established body of evidence that high fees and active management are not in the best interest of investors. Commissions are often blamed for influencing the questionable advice that many financial advisors give, but there may be a much more innocent explanation.

As of December 2017, 89% of Canadian investment fund assets were invested in mutual funds, with the remaining 11% invested in ETFs. A 2017 Morningstar study of the Canadian mutual fund landscape showed that the majority of mutual fund assets in Canada are in commission-based products. These are typically actively managed mutual funds that pay a trailing commission to the financial advisor that sold them. It’s probably safe to conclude that many Canadians are still relying on the advice of financial advisors selling commission based products.

The lack of a fiduciary duty for most financial advisors is often blamed for the generally poor financial advice that many retail investors receive. A 2015 study commissioned by the Canadian Securities Administrators showed that Canadian financial advisors are likely influenced by commissions. Similar studies in other countries have concluded the same thing, leading some countries to ban mutual fund commissions altogether.

Commissions do seem like a sensible explanation for the bad financial advice that so many Canadians receive, but what if there is a bigger issue? We know that the barriers to entry for becoming a financial advisor are quite low. If financial advisors don’t necessarily have a great understanding of investing and portfolio management, it is feasible that their bad attempts at giving good advice are simply misguided.

A 2016 study titled The Misguided Beliefs of Financial Advisors looked at this exact issue. The study looked at more than 4,000 Canadian financial advisors, and almost 500,000 clients, between 1993 and 2013. By comparing the accounts of the advisors to the accounts of their clients, the study authors were able to test whether advisors were also acting on the advice given to their clients in their own personal accounts.

If, for example, financial advisors were selling expensive actively managed mutual funds to their clients while investing in low-cost index funds in their personal accounts, we would suspect a conflict of interest. If advisors were buying expensive actively managed funds in their own accounts, we would suspect that they really believed that to be a wise investment.

The data show that both advisors and their clients tend to exhibit performance chasing behaviour and an overwhelming preference for actively managed mutual funds. They also both had poorly diversified portfolios and owned funds with high fees, but the advisors own portfolios actually had worse diversification and higher fees than the clients. All of these tendencies are well documented as being detrimental to long-term returns. The study also shows that financial advisors typically continue with these behaviours once they have retired, ruling out the possibility that they hold expensive actively managed portfolios only to convince clients to do the same.

This evidence makes a strong case that the many financial advisors selling expensive actively managed investment products may be doing their best to give good advice based on their own misguided beliefs. None of this should come as a surprise. A license to sell mutual funds is not terribly difficult to obtain, and fund companies pour resources into convincing financial advisors that they should be selling actively managed products to their clients.

The possibility that many financial advisors are misguided in their beliefs has important implications for investors. A 2017 white paper from Vanguard titled Trust and financial advice shows that one of the most important factors that investors consider in assessing the trustworthiness of their financial advisor is the expectation that the advisor will act in their best interest at all times.

Of course having someone looking out for your best interests should be valued, but well-meaning advice from a misguided financial advisor is just as damaging as malicious advice. If you need financial advice, seeking out a financial advisor with advanced financial education and an understanding of the evidence supporting the use of index funds could be a sensible solution.

It is always a good idea to ask your financial advisor what they think about index funds. The right answer, and there is a right answer, is that index funds are the most sensible approach to investing for most people.

Do You Need Alternative Investments? Part III: Hedge Funds

I’ve talked before about the tendency of investors to feel like they deserve more than the plain old market return. This seems to be especially true as people build more wealth. Anybody can buy index funds. More sophisticated investments have high minimums, or require you to be an accredited investor. The pinnacle of what I am describing is investing in hedge funds. Hedge funds are exclusive, elite, expensive, and lightly regulated financial products.

There are about 3.3 trillion dollars invested in hedge funds globally, and they continue to grow as an asset class, despite suffering from continued performance that lags a portfolio of low-cost index funds.

The first hedge fund was set up by Alfred W. Jones in 1949. His fund, A.W. Jones & Co, was the first fund to invest in stocks with leverage while using short selling to remove market risk. He structured the fund as a limited partnership to avoid regulation. None of this innovation would have mattered except for one important detail: the fund did really really well. We know that funds that have done well in the past are no more likely to do well in the future, but Jones’ success was publicized in Fortune magazine, and hedge funds were born.

Today there are a lot of different hedge fund strategies. They are typically designed to have performance that is uncorrelated with the market. The Credit Suisse hedge fund index shows that hedge funds have done an okay job at accomplishing this goal. While relatively low correlation with other asset classes can be seen as a good thing in an overall portfolio, the high costs, low returns, and additional risks of owning hedge funds must be considered.

Hedge funds command high fees due to the supposed skill of their managers. They will typically charge 1-2% of the assets under management, plus 20% of any excess performance. In a 2001 study Hedge Fund Performance 1990 - 2000: Do the ‘Money Machines’ Really Add Value Harry M. Kat and Gaurav S. Amin found that the weak relationship between stock returns and hedge fund returns is not attributable to manager skill, but to the general type of strategy that hedge funds follow. Any fund manager following a typical long/short type strategy can be expected to show low systemic exposure to the market, whether he has special skills or not. This leads to the question of why investors would pay such high fees.

The exclusive nature of hedge funds would lead most people to believe that they must also have high returns. This is refuted by the data. The Credit Suisse Hedge Fund Index shows an annualized return of 7.71% from January 1994 through November 2017, while a globally diversified equity index fund portfolio returned 9.19% over the same period. Even a much more conservative index fund portfolio consisting of 60% stocks and 40% bonds outperformed the hedge fund index, returning an average of 7.75%.

Between high fees, lacking evidence of manager skill, and low average returns, hedge funds aren’t sounding so good. Wait until I tell you about the risks.

Hedge funds do not have the same kind of liquidity that an ETF or mutual fund has. Investing in a hedge fund will typically involve a lock-up period during which your funds are not accessible. After the lock-up, hedge funds can suspend investors’ ability to withdraw from the fund at their discretion. That would typically happen at the worst possible time, like if the fund is crashing.

One of the pitches of hedge funds is that they are less risky than stocks, as shown by their relatively low standard deviation of returns. Standard deviation does not tell the whole story. Hedge fund returns exhibit negative skewness and high kurtosis. In plain english, that means that most investors lose while a few winners win big, and the funds exhibit exceptionally high and low returns with greater frequency than would be expected in a normal distribution.

One of the reasons that they seem exotic is that hedge funds can invest in anything. It might be cool to tell people about over dinner, but in reality it means that the riskiness of the underlying assets can be more extreme than you might expect. A 2000 study by AQR Capital Management found that many hedge funds were taking on significantly greater risk than their benchmarks by investing in illiquid assets.

Illiquid assets could result in outperformance due to the illiquidity premium, but investors may have been taking on far more risk than they realized. Hedge funds also employ leverage. The combination of illiquid assets and leverage can be disastrous for hedge funds during bad markets, especially if investors ask for their money back. A worst case scenario would see the hedge fund having to unwind illiquid positions at a significant discount, resulting in losses for investors.

Despite the hype about low correlation, hedge funds are a poor combination with equities. While we know that hedge funds have a somewhat low correlation with the stock market, that correlation can become high at the worst possible times. This is exactly what happened in both the 1998 and 2007 financial crises. So while the correlation data may look good on paper, it may not be very useful in practice.

Even if there are hedge funds out there with great returns, remember that past performance is a terrible predictor of future results. One prolific example of this is the Tiger Fund. It was formed in 1980 with ten million dollars and went on to average returns over 30% for the next 18 years. Wow. By 1998, it had over 22 billion under management, most of that coming from new investments wanting to get in on the performance. Tiger then stumbled badly, losing ten billion dollars, before closing in 2000. The funny thing is that while the fund still shows a 25% average annual return, it is estimated that most investors lost money because they invested after all of the great returns had been earned.

High profile hedge fund failures have not stopped many investors from allocating capital to hedge funds. One of the largest failures, Long Term Capital Management, cost billions of dollars and almost resulted in a global financial crisis. That was in the ‘90s, and hedge funds have continued to grow.

In 2014, CalPERS, a massive California pension fund and one of the leaders in the institutional investment space, made the decision to exit hedge funds as an asset class in their portfolio. They made the decision to shut down their hedge fund program primarily due to the program's cost, complexity, and risk. Other large pension funds have since followed suit.

Eugene Fama, Nobel Prize winner and the father of modern finance, said “I can’t figure out why anyone invests in active management, so asking me about hedge funds is just an extreme version of the same question. Since I think everything is appropriately priced, my advice would be to avoid high fees. So you can forget about hedge funds.”

Warren Buffett famously won a 10-year million dollar bet against a hedge fund manager who was allowed to select five hedge funds to beat the S&P 500 index. The index won out easily. Buffet can’t predict the future, but the odds were certainly in his favour.