Jack D. Schwager, the man behind the successful “wizards” books, has given us a volume without “wizard” anywhere in the title: Market Sense and Nonsense. The subtitle amplifies the contrast already present in that title: How the Markets Really Work (and How They Don’t).
We will focus here on the portions of his book that most concern the world of hedge funds and other seekers of alpha. Schwager devotes a good deal of attention to this question: suppose your inquiries find a hedge fund with a temptingly impressive track record. How much of its return represents the skill of the fund manager?
In mutual funds, he tells us, fund results tend to follow the pertinent benchmark indexes, indicating that skill is “dwarfed by the market or sector influence.” In hedge funds, the relevance of past returns to manager skill is a more complicated issue, although Schwager doesn’t necessarily end up in a much different place.
Prior Best Funds and Strategies
The relevance of talent to track record depends in large part on the specific strategy a hedge fund employed in acquiring that record. Schwager expects that past returns for a merger arb fund will reflect the level of merger activity during the period covered by those returns, not the skill of the managers. Further, since “there is no reason to assume that past merger conditions will have any predictive value for the level of future merger activity,” this is a strategy and a category of hedge funds where investors might take especially to heart the usual bromide that part performance is no guarantee of future results. Not only is it no guarantee, it might be an inverse indicator, given the tendency toward ebb and flow of the deals on which the merger abs thrive.
In general terms, the more dependent results have been on market or strategy, the less valuable they are as an indicator of skill, and indeed the more likely that the good past results only tell you about something that is, in every sense, past.
Suppose you simply create a portfolio based on the strategies that have worked best in the preceding five year period.
As you can see from the above graph, both the average and the “prior worst” approaches do much better than does the “prior best” defined in that way.
This is not to say that Schwager is a Cassandra of the hedge fund market. On the contrary, in some respects at least he believes that the potential value offered by hedge funds has been left sadly neglected. He writes that it is unfortunate that retail investors are scared away from the whole alternative investment world by certain innate psychological biases. It is comparable to the way in which “some people drive long distances to avoid the risk of flying when the chances of their being killed in an automobile per mile traveled are far higher.” [A long-only equities portfolio, or a mutual fund that in turn holds such a portfolio, is the lengthy auto trip in that analogy.]
I spoke to Schwager recently and asked him to expand on this point. He said: “The view that hedge funds are the wild west of finance and stocks are a conservative investment has things backwards. In fact, empirically, diversified hedge fund portfolios have similar long-term returns as equity indexes but with much smaller equity drawdowns. The question should not be: would you have your grandmother invest in a fund of hedge funds? It should be: would you have your grandmother invest in stocks?”
Not a Mirage
Readers of AllAboutAlpha will recognize that we have run expressions of skepticism about the critique of the hedge fund industry associated with Simon Lack, the author of The Hedge Fund Mirage. Lack has claimed that the industry underperforms the classic risk-free asset, U.S. treasury bills.
Schwager, too, engages with Lack. Correcting what he sees as Lack’s errors in method, but using the same hedge fund index Lack used, and the same starting year (1998), Schwager finds that the return for the hedge fund index should be 5.49 percent per annum, versus just 2.69 percent for the T-bills.
Running the comparison with long-equity positions, Schwager also notes that during the same period, “the S&P 500 generated an average annual compounded return of only 1.0 percent above T-bills with far greater volatility and drawdowns.”