A major debate in 2008 will undoubtedly rest around hedge fund transparency. With all the losses that have been publicized and the ones that I'm sure will come about between now and then, there will probably be a call to arms for hedge funds to make their holdings publicly available. In his book A Demon of Our Own Design, Richard Bookstaber argues against this, stating, "I believe much of what is proposed for hedge fund oversight and analysis will turn out to be a fruitless exercise because the concept of hedge funds defies a meaningful definition." He continues to argue that by his categorizations of hedge funds, it is not crazy to assume that almost any investment could be considered a hedge fund, and that traditional and "long-only" investments are simply more constrained to these factors most notably to direction and investment type.
This was an interesting observation and I could not agree more with him. He argues that eventually they will converge and that there is little difference between a long/short equity fund and a long only - except for the freedom that they have to work with. What is disconcerting, however, is that the average investor can not invest in these funds. Although this trend is shifting, and many pension assets are in the funds, the average investor is restricted from investing in a fund that is better suited to outperform his fund. This has created a segmentation of investment products from luxury to bargain, and it may be necessary to rethink the recent popularity of ETF'S and asset allocation.
Much of the ETF/Indexing and Asset Allocation boom has been built on the foundation of the Efficient Market Hypothesis. The EMH basically states that markets price in all relevant information and that instead of trying to actively pick securities to "beat"the market, but rather adhere to a passively managed, diverse portfolio of index funds. While I will not go into them all in depth, there are a few assumptions that make the efficient market hypothesis "work". This includes the assumption that investors have rational expectations - meaning that they are not necessarily rational but when given new information, update their expectations appropriately.
For years this was the theory that Wall Street loved to hate because it devalued what they did, which was picking investments and managing money. During the dot-com boom, Wall Street's position as essentially being short the EMH was a very good one, but after the bust, Wall Street had to change - at least on the retail level.
Sometime during all the dot-com mania a product called an Exchange Traded Fund (ETF) came about. An ETF is a closed-end fund that tracks an index. Unlike most closed end funds, ETF's are very liquid because of a concept call "in-kind transfers" and enable the investor (or trader) to buy and sell indices at will. These funds grew in popularity as the average investor was very skeptical of Wall Street, Active Managers, and analyst research. They were very "cutting-edge" in their simplicity and freedom and at the same time anti-establishment in that they were low cost, low maintenance, and could be traded easily at a discount broker like E-Trade or Schwab.
Wall Street, although first slow to embrace the idea, has worked ETF's into their business model by creating indexes and selling advice on how to diversify a passive (and/or active) portfolio - more commonly known as asset allocation. Sell-side research has been replaced with in-house strategic and tactical asset allocations based mostly on style, asset class, sector, and geography. They have scrapped their in-house funds and instead of selling their research and products, they have sold financial planning and asset allocation. This, I have believed to be almost unanimously a great thing for the average investor, as it took away many conflicts of interest and the opportunities for mania and irrationality. After reading Bookstaber, however, I have grown a bit skeptical.
One of the few stories that has been more popular the past few years than Wall Street's move towards ETF's and asset allocation, has been hedge funds and private equity. Very secretive in nature, spectacular in their returns, and unobtainable to the average investor, they have evolved from an obscure investment vehicle to rock-star status over the past few years.
Hedge funds' success rests on the bet that markets are NOT efficient. They usually rely on some sort of arbitrage opportunity which they take on leverage to try to expose and earn a return. In order to do this, they contend that they must keep their holdings secret and must take on a large amount of risk (although their main selling point is that they are in a hedged position, which by should reduce risk). In an efficient market, arbitrage is not a mechanism that makes it efficient and therefore the investor should not engage in such an activity, as the investor is fighting forces much quicker and stronger than he is.
Another factor that hedge funds' success rests upon is liquidity. They bet that a market is currently irrational or inefficient and in a move towards rationality and efficiency, will provide liquidity so that the fund can get out of their highly leveraged bet. If they are unable to find liquidity in the case that the market does not go their way, they are in big trouble. This, they argue is a need for secrecy of their holdings. If their holdings are known, then they can come under attack or will not be profitable. Essentially, the market would become more efficient - eroding away the inefficiencies that they fight so hard for.
As mentioned earlier, a major assumption supporting the EMH and forming the basis of many investor's portfolios is of rational expectations. This is rooted on information being readily available and the aggregate reactions of investors being normal. The segmentation of investments into hedge funds and ETF's, however, causes a disconnect between the amount of information advantage an investor has. Many hedge funds would tell you that if their positions were revealed, they would be a sitting duck, vulnerable to having their positions attacked and starved from liquidity. ETF investors have the most publicly available positions on the street. ETF holdings are updated daily and they are based on readily available indexes. In addition, due to the passive nature of such a vehicle, its holders are usually not responding at all to new relevant information, and its holdings are being sold long and short by people who have much more information than they do based on the sheer fact that they have no idea what hedge funds hold.
While hedge funds may not know what each other holds, they all know what the rest of the market is holding, and more importantly, they know to a degree how their actions will be countered by a segment of the market - since ETF's are by nature passive. This is the financial equivalent of excellent video game players playing the computer versus playing each other. The good players will consistently beat the computer if they know that the computer is predictable in how it executes plays and reacts to the player's own moves, whereas the other human player is a very tough out. This is all supported by the fact that these investments have the indexes they follow as a benchmark. The investors will never see what they could have made if they didn't invest in the ETF, but only what the index did itself, therefore the incentive to change out of a position is much smaller, because there is a sense of accomplishment and goal-fulfillment. One only has to look at the performance of sectors of the S&P 500 Index to see how this may be panning out. If you look back over the last four years, when ETF assets grew tremendously, the best performers - Energy (174%), Materials (50.74%), and Utilities (47.22%) only make up about 18% of the S&P 500 index TODAY - in 2003 before their appreciation, they made up even less. On the other nand the worst performers, Healthcare (-22.14%), Consumer Discretionary (-19.05%), and Financials (-11.03%) make up 41.3% of the index. In 2003, this was closer to half the index.
The disparity between Small/Mid Cap and Large Cap companies as well as International and Emerging Markets has been similar during this time period and hedge funds like to dwell in this space, while asset allocations models are usually biased towards large cap domestic equity exposure - due to its historical great performance and risk characteristics - although that is changing as the latest data entering the system is skewing it the other way. This leads to the second vulnerability of these models, and their passive nature is that they have a bias in being behind the curve. As many of the back testing of risk and return parameters goes back 20 or so years, some may tend to rebalance towards investments that have performed well and out of those that have. This is not the case with all, but some do. It also opens the Financial Advisor up to the ability to make misleading presentations by creating an asset allocation proposal that allocates more heavily these winners, and may be a way of winning business, while creating liquidity for the actual winners, the hedge funds.
In the tech boom, when the average investor became a trader some of them foolishly lost their shirt and learned a great lesson from it. There were, however, others who did not and were able to build actual wealth - I know many who have and are doing very well today because of it. ETF's and asset allocation may be dangerous in the fact that underperformance is invisible due to the absence of a benchmark, which was always has been a gauge for opportunity cost risk. Instead, the benchmark has become those hedge fund and private equity investors who earn returns that are not readily available and whose investments are unseen. These investors then use the sitting ducks in ETF's as a benchmark - the same investors whom they carry an informational edge and are given leverage to eat away any alpha that this group as a whole ever realized. One group of the investors gets to play in reality (an inefficient market), and given tons of money to do so, the other group is forced to play in fantasy land (the efficient market), but told and are reinforced to the otherwise.
As hedge fund managers continue to pop up in the Forbes Billionaires list by being able to long and short stock, hedge currency risks, and invest in commodities on enormous leverage around an investor who captures a skewed mean of it all in a cash account, this disparity will most likely become more and more apparent. Hopefully, it will not result in less freedom for all but for more freedom for the many, but I am not so confident in the latter panning out. Moreover, I hope that I am wrong, and that this imbalance is temporary, and the passive investor wins out, but more and more it seems that the stakes are too high to let something like that happen - especially if it is the "efficient" outcome"
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