Hedge Funds – not so clever after all

Trading Places

David Harding ( Winton Capital ) has for many years been quoted as a superhero of the hedge fund world. Harding’s meteoric rise began when he founded Adam, Harding and Lueck (AHL), where he and his two partners used trend following techniques to build a profitable business which was subsequently sold to the Man Group.

In the early days this sort of activity was made famous by the Turtle Trading experiment and the Eddie Murphy film Trading Places was based on Turtle Traders William Eckhart and Richard Dennis.

These people used to be called “Commodity Trading Advisors” and for many years conditions were right for great fortunes to be made, although such fortunes tended to accrue more to the managers than investors, given the huge fees charged by hedge funds.  And given the fact that most investors sold out during the terrifying periods of drawdown and so never captured the sort of long term profits the managers track record might seem to promise.

People like Michael Covel wrote popular books on the subjects and sells course, even though by his own admission he is an “educator” and not a trader or fund manager.

I won’t bother to quote you figures, you can easily enough see track records on websites like CTA Performance. 

Trading_Places

The point is that in the glory days of the strategy all went well. Recently the techniques have fallen on hard times and that is the story of hedge funds in general.  There is a right time and place for a given strategy: people who by luck or judgement are in the right place at the right time benefit but in the end the markets humble them.

JW Henry was a hugely successful trend follower but his company went out of business when his methods no longer cut the mustard.

Winton and other trend followers have disappointed in recent years also. As methods decline, investors begin to leave.  Winton are at least shrewd enough to have reduced their volatility by cutting leverage since the early glory days and will presumably survive albeit in a less exciting form. Many lesser players are likely to crash and burn. Many have already done so.

Trend following itself is old as the hills and no one can profit in markets without trends. If stock markets did not trend upwards, the only source of income would be from dividends and stocks would be more like bonds.

Very often the hedge fund managers have represented nemesis writ large and the story of Long Term Capital Management is one of the most notorious examples.  Despite the involvement of economic Nobel prize winners Scholes and Merton, this disaster had to be bailed out by the Federal Reserve in 1998 to prevent what may well have resulted in a collapse of the world financial system.

Robert C. Merton and Myron S. Scholes shared the 1997 Nobel Memorial Prize in Economic Sciences for a "new method to determine the value of derivatives".
Robert C. Merton and Myron S. Scholes shared the 1997 Nobel Memorial Prize in Economic Sciences for a “new method to determine the value of derivatives”.

The problem is that few can see that most of the success of investment managers has been down to luck over the years rather than skill. Being in the right place with the right ideas and techniques at the right time.  Markets change and record returns turn to record losses or at least stagnation.

Myron Scholes By The original uploader was Nobellaureatesphotographer at English WikipediaCC BY-SA 3.0
Myron Scholes By The original uploader was Nobellaureatesphotographer at English WikipediaCC BY-SA 3.0

Trend following CTAs success may have been their own defeat: too many people with too much technology jumping onto the bandwagon.

For decades the hedge fund managers were Masters of the Universe.  They are now seen as mere mortals after all. An industry which promised all weather performance and an alternative to traditional stock and bond investment has been shown to be yet another fad.

Crispin Odey is another example of a hedge fund manager who appeared to perform well for some years and was then hit by severe misfortune.  Investors will probably have suffered rather more than Mr Odey.

Crispin Odey
Crispin Odey

 

Whether the technique used is trend following, convertible bond arbitrage, or any other hedge fund technique, in the long term the winners tend to be the managers who cash in enormous fees of 2 and 20 or more when things are going well and do not have to pay any of that back when they crash or move to mediocrity.

In the very long term you are probably better off relying on wide diversification and simplicity  using simple “buy and hold” of traditional stocks and bond portfolios.

 

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