As reported yesterday by Bloomberg, “The New York City pension for civil employees voted to exit its $1.5 billion portfolio of hedge funds and shift money to other assets, deciding that the loosely regulated investment pools didn’t perform well enough to justify the high fees.” They are echoing the announcement by the giant California pension system CalPERS to divest starting in late 2014 (divestment this extensive normally takes years to unwind). And this coincides with a general pension fund dissatisfaction, as reported last June by the Wall Street Journal, as their hedge fund investments severely underperformed compared to the previous five-year stock market rally.
Hedge funds were so named because of their ability to create a portfolio by combining the purchase of assets (“going long”) and the “shorting” of them (selling in anticipation of buying back later at a lower price). No matter which direction markets went the portfolio was supposed to benefit. If successful that meant returns would be consistently positive with none of the dramatic swings seen by just owing stocks.
Popularity for the idea soared in the early '90s after the published success of Julian Robertson’s Tiger Fund. As hundreds of fund managers crowded into the field, the strategy changed from simply buying or shorting stocks. Managers would range all over the world looking for mispriced currencies and commodities. Trend followers would buy into positive or negative momentum, hoping to get out before the direction changed. Rather than trusting human foibles many created complex algorithms (computer programmed formulas) based on minute but persistent anomalies in markets. Since most of the trades produced too little profit per trade, leverage (borrowing) was needed to enhance the overall return.
What followed, not surprisingly, happens when any good investment idea becomes too “crowded”. Entry into and exit from a strategy became more expensive and the good ideas were either gone too quickly or less lucrative as the total return was divided between more participants.
Fundamentally, most hedge fund strategies take place on a world poker table. I only win by being smarter than you, selling you falling assets and buying from you rising assets every month, year after year. Not surprisingly, you’re smart too, so the years are marked by a back and forth with significant trading expenses and operational costs subtracting from both our overall returns. Small wonder pension funds grew disenchanted.
Meanwhile, those investors searching for a long-term portfolio of good companies with proven management, durable products, and sustainable growth succeed through the decades. You and I might have furiously traded back and forth over the years the stocks of any number of household names, yet we would have both been well off because the total value of those companies kept growing. By buying GPM Grade companies at good prices and avoiding the furious trading, GPM expects to benefit from true wealth creation at a modest cost.