The Real Reason Why Hedge Funds Can No Longer Compete With the Market

In the past, hedge fund giants were able to completely dominate capital investments, allowing them significantly exceed what the market could offer. But this trend seems to be quickly dissipating.

 

For an investor, identifying where an opportunity set lies is the largest obstacle in turning their ideologies into a viable plan of action. To add to the burden, the competition in the investment sector is at an all-time high, leading to a difficulty in providing the exclusive market standard sought after by investors looking to liquidate in institutions.

“The Incredible Shrinking Alpha,” authored by Larry Swedroe and Andrew Birkin – the former being an author and the latter being a leading investor – is a book covering the ins and outs of why promises of apex performance are extremely hard to follow through on and even harder to implement. It contains detailed case studies and is backed by empirical evidence that suggests that risk-adjusted outperformance, also referred to as the “alpha” in colloquial investor-speak, is a standard which is becoming increasing difficult to attain.

One might conform to the age old proverb that professionals can be beaten by monkeys when in reality they are all emperors without clothes – but this is not the actual reason. Believe it or not, it’s completely contrary. Professional investors are better educated, more researched, and therefore significantly more competitive in comparison. Unfortunately, due to a scarcity of resources in the market, this competition is a much smaller, fragmented reward.

In the words of Michael Mauboussin, this awkward phenomenon is called the paradox of skill. He argues that it is not managers who have a lower capability as against what they did in the past. In contrast, the average manager is significantly superior in their skills and ability than, let’s say, ten years ago. But the paradox of skill dictates that when competence and luck are considered as factors, the more that power is incremented, the more that the outcome is based on luck. The question that needs to be asked is: how many investors looking to invest in institutions consider whether the parties they are investing with are lucky, or skillful in reality?

David Hseih, a finance professor at the business school of Duke University, found, in his work, that there is an available capital of $30 million concerning risk-adjusted outperformance as potential investments for the hedge fund industry. Assuming this number is accurate, a bit of mathematical analysis reveals to us that in 1990, about six hundred hedge funds competed to close $40 billion worth of assets. Now, the number of hedge funds exceeds itself well into five digits, collectively in-charge of about $3 trillion. A $30 billion Alpha can only be divided evenly when the funds don’t exist – but alas, they do, and that is why hedge funds today are struggling.

William Bernstein, after a study on hedge funds for his upcoming research “Skating Where the Puck Was” was able to demarcate timelines where hedge funds did well – such as during the initial years of 1998 to 2002 – where they earned a positive alpha of 9%. In the following years, the alpha dropped gradually, eventually amounting to a negative -4.5% between 2008-2012.

These studies, in their essence, highlight that investors – especially individual ones – should realize that even the multinational corporate giants having over a billion’s worth of assets and a team of highly-trained professions are currently struggling in the market. The solution now is to focus on areas overlooked by large investors, not compete with the creme de la creme.

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