There are many types of funds.  The funds that I am referring to are mutual funds and hedge funds, or actively managed funds.  Index funds are passively managed, in that they simply track the indices, such as the S&P 500 or Nasdaq.  According to U.S. News:

index funds “beat 89.84 percent of all actively managed…funds.”

Mutual Funds

Mutual funds underperforming the index is old news.  There has already been a lot of discussion on why mutual funds underperform.  Forbes provided 5 reasons.  In summary, they are:

1. Too much diversification:  Fund holds too many stocks.  If it is holding so many stocks, it will likely perform similarly to the index.
2. Fees of 1 to 2.5 percent:  Even if the fund can match the index, which most do not, then you will get the index’s return less 1 to 2.5 percent.  This 1 to 2.5 percent will magnify your underperformance significantly, through compounding over 10-15 years.  See Your Portfolio After Fees.
3. Cash on Hand:  Funds tend to have a percentage of the portfolio in cash.  As you know, cash provides zero return.  You can manage cash just as well as any professional.  Why would you pay someone else to stare at your cash?
4. Money Manager Psychology:  They follow other fund managers and buy the same stocks.
5. Trade too often:  They trade too often, which incurs trading costs.

I would like to add the following reasons:

• Many mutual funds hold 100 stocks.  No human can thoroughly understand and monitor 100 companies, not even a team of humans.  To pick 100 stocks, you need to filter and research many more than 100, in order to come up with a short list of 100.
• Fund managers tend to chase after stocks and trade too often.  Essentially, they are traders instead of investors in businesses.  For an explanation on the difference between the two, read Top 4 Reasons to Invest in Stocks.  I did too much trading and I learned that lesson the hard way.  For explanation, read How to Beat the Hedge Funds and Warren Buffett.

Hedge Funds

Most people know that mutual funds lack lustre.  However, most people think that hedge funds are outperformers because they are for the elite, accredited investor class.  This is a myth.  While some hedge funds do outperform, the majority do not.

The original purpose of hedge funds was to hedge against risk.  In other words, reduce losses.  To do this, they can short stocks or use derivatives.  There are costs associated with doing a hedge.  Shorting means that you will make money if the price goes down.  To short, you borrow the stock, sell it and hope to buy it back when the price is lower.  Shorting a stock means that you will be paying interest to borrow the stock.  If the stock stays flat, you still lost money which is the interest that you paid.  To use derivatives, you have to buy them.  A put option is one type of derivative.  I’ll use a simple example to explain how it works.  It costs $1 to buy the put option and the put option will be worth $2 if the price of the stock goes down, otherwise it will be worth nothing.  If the stock does not go down, you lost the $1 that you paid for the put option.

If the fund incurred the cost of the hedge when the stocks stayed flat, then this means that performance suffered.  If they hedged during upturns, then they lost even more.  They would have incurred the cost of the hedge and they would not have realized as much gains as they would have if they were “long” only.  Since the stock market goes up more often than not in the long run, many hedge funds incurred the cost of hedges when they did not need to.  This is one of the reasons that many hedge funds underperform compared to the index.

Another reason is that hedge funds are managed by humans and most humans have emotions and short-term outlooks.  Their emotions make them afraid of volatility and short-term losses.  They are still susceptible to trading too often or chasing after stocks.  They trade too often because they are measured by yearly, or worse, monthly performance numbers.  Instead, all fund managers should be measured on multi-year performance.

Investors are able to hound or pressure the hedge fund managers to not lose money for that month, much more so than with mutual funds and especially if the investors are big institutions or pension funds.  Hence, you hear on the news about hedge funds trying to time the market, by selling during corrections instead of holding on.  Therefore, they tend to become traders instead of investors in businesses.

So why do people buy hedge funds?  My theory is that fear is more powerful than greed.  My theory is that people are more scared of volatility and losing money than they are interested in making money.  However, by reducing the volatility of a fund, you also reduce the performance.  There is good evidence of this.  I will explain below.

As shown in How to beat the Hedge Funds and Warren Buffett, I significantly outperformed.  I came across an article about a person, who I will call Mike, who was seeking hedge fund managers.  I sent my performance numbers to Mike, who works at a Wall Street firm.  He used his program to crunch my numbers to come up with the Sharpe Ratio.  You might have heard of “risk-adjusted return”.  The Sharpe Ratio measures risk-adjusted return.  The higher the ratio, the lower the volatility and risk.  The lower the ratio, the higher the volatility and risk.  Generally, the industry prefers a high ratio.

Mike wrote back to tell me that my volatility was way too high and that emerging managers are held to a higher standard.  He told me to focus on performance and lower volatility.

Fair enough.

I wrote back with the following:

“Thank you for your reply and feedback.

Is it possible that my low Sharpe ratio is due to my significantly higher return in 2009?

I calculated the following annualized Sharpe ratios, using risk free rates of 2.7% to 2.8% and annual returns:

	Me	S&P 500
2008-2013	0.15	0.05
2009-2013	0.38	1.12

When I changed my 2009 return to be equal to S&P 500’s returns, this is what I get:

	Me	S&P 500
2008-2013	0.33	0.05
2009-2013	1.06	1.12

If I lower my 2009 return further to 10%, my Sharpe ratio becomes higher than S&P 500’s 1.12.  If I increase my 2009 return to 200%, my Sharpe ratios become tiny.

Is it possible that many funds that significantly outperform the index are going to have higher volatility and lower Sharpe ratios?

There are thousands of funds that cater to different types of clients.  Many of them are getting sub-index performance, which means that they might have better Sharpe ratios than what the index has.  Are there any clients who want alpha and to make more money?

According to http://www.investopedia.com/articles/07/sharpe_ratio.asp :

“Herein lies the underlying weakness of the [Sharpe] ratio – not all asset returns are normally distributed.

Abnormalities like kurtosis, fatter tails and higher peaks, or skewness on the distribution can be a problematic for the ratio, as standard deviation doesn’t have the same effectiveness when these problems exist. Sometimes it can be downright dangerous to use this formula when returns are not normally distributed.”

With very high positive returns in 2009, is it possible that I have “skewness on the distribution”?”

I thought that logic was on my side.  Even if a fund never underperformed in any year, but significantly outperformed in one or more years, its volatility was going to be higher and its Sharpe Ratio was going to be lower.  Wouldn’t investors disregard the Sharpe Ratio and want the alpha (higher performance)?  Wouldn’t investors want this extra money?

Instead of agreeing with my logic, Mike replied and succinctly told me that the Sharpe ratio needs to be greater than 1.5 before institutional investors will look.

Huh?

For the hedge fund to have such a high Sharpe Ratio, this implies that the hedge fund is significantly underperforming the S&P 500.

Why would investors want such low performance?  The only reason that I can come up with is that investors are more scared of volatility than they are of making money.  This is one of the reasons that some investors will accept the pathetic 2% yield on fixed income investments even though it has been shown for approximately 100 years that stocks outperform fixed income in the long run.

Due to this focus on Sharpe ratios, some investors can miss out on any high performing funds.  The fund can be providing high positive returns every year but the investor will not look at it because the Sharpe Ratio is too low.  If you work on Wall Street, maybe you can shed more light on this.

Hedge funds need to manage a LOT of assets to make a living.  According to Citi:

“…hedge fund managers need at least $300 million AUM [assets under management] to break even.”

Hence, hedge funds need institutional investors.  If these investors want 1.5 Sharp Ratios, hedge funds will give it to them…along with the low performance.

So, as an asset class, I would put most hedge funds somewhere in between equities and fixed income.

Read Top 4 Reasons to Buy Stocks and Allocate 100% of portfolio to stocks!!