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Note from the Editor: Larry Swedroe offers his thoughts in today's commentary. If you would like to comment on this piece, feel free to contact Larry directly.
Today's Commentary: 12.06.04
Hedge Funds and the Tyranny of the Efficiency of the Markets
by Larry Swedroe
In a search for a safe haven during the bear market for stocks that
existed from 20002002, hedge funds attracted more than the usual
attention. And in the aftermath of that bear market, they continue to
attract much attention.
Over the past three years, the number of hedge
funds has about tripled, as have assets under management, which are now
estimated to be as much as $1 billion. Unfortunately, as the historical
record on hedge funds clearly demonstrates, that is bad news for the
typical investor that is mesmerized by the hype and the exclusive nature
of the club.
The academic record on hedge funds is, at best, a very poor
one. Once the historical returns data is adjusted for all the biases
(i.e., survivorship, instant history, liquidation, self-selection, lack
of liquidity, and non-normal distribution of returns) in the data, hedge
funds have provided risk-adjusted returns that are in the neighborhood
of riskless Treasury bills. And since there is no evidence of any
persistence in performance, beyond the randomly expected, there is no
way to identify, at least ahead of time, the few star performers in the
game. Why do hedge funds have such poor track records? The answers are
actually quite simple.
There are actually two types of hedge funds. The first are just
active mutual fund managers in disguise. These types of hedge funds
believe that they can identify which stocks are overvalued (avoiding or
shorting them) and which are undervalued (overweighting them). They may
also believe that they can time the market. Unfortunately, as stated
above, the evidence is very much to the contrary.
The other type of hedge fund is one that attempts to exploit arbitrage opportunities.
Arbitrage is the process by which investors exploit the price difference
between two exactly alike securities by simultaneously buying one at a
lower price and selling the other at a higher price (thereby avoiding
risk). This action locks in a risk-free profit for the arbitrageur
(person engaging in the arbitrage). Funds that engage in arbitrage are
truly hedge funds - as opposed to mutual fund managers in disguise. Given
the potentially huge rewards for discovering arbitrage opportunities,
and the amount of brain and computer power available, it would be
foolish to think that there would never be arbitrage opportunities that
could be exploited, at least temporarily.
An example of how hedge funds could theoretically prosper comes from the
world of convertible bond arbitrage. A hedge fund operating in the asset
class of convertible bonds might, for example, be able to buy a
convertible bond, simultaneously short the equity of the issuer, and
lock in a profit. Or, the fund manager might simultaneously go long the
equity and short the convertible bond. In either case it is possible
that a profit could be locked in without accepting any net exposure to
the risk of the stock.
Searching for these anomalies seems like a very
attractive proposition. Unfortunately for hedge funds, and their
investors, the process of arbitrage rapidly brings prices back into
equilibrium.
Purchasing the undervalued security raises its price and
shorting the overvalued one lowers its price. This is the power of the
efficient markets hypothesis, as expressed by economics professors
Dwight Lee and James Verbrugge of the University of Georgia:
"The efficient markets theory is practically alone among theories in that
it becomes more powerful when people discover serious inconsistencies
between it and the real world.
If a clear efficient market anomaly is
discovered, the behavior (or lack of behavior) that gives rise to it
will tend to be eliminated by competition among investors for higher
returnsŠ(For example)
If stock prices are found to follow predictable
seasonal patternsŠthis knowledge will elicit responses that have the
effect of eliminating the very patterns that they were designed to
exploitŠ
The implication is striking. The more empirical flaws that are
discovered in the efficient markets theory the more robust the theory
becomes. (In effect) Those who do the most to ensure that the efficient
market theory remains fundamental to our understanding of financial
economics are not its intellectual defenders, but those mounting the
most serious empirical assault against it."
The arena of convertible bond arbitrage provides the perfect real
world example of Lee and Verbrugge¹s insight. The amount of money
flowing into convertible bond arbitrage has been so great that it is
estimated that today about 95 percent of all trading in convertible
bonds is done by hedge funds.
Given that high percentage it is hard to
imagine that there are enough victims to exploit! By the time investors
are able to identify a hedge fund with the skills needed to exploit a
market anomaly the "tyranny of the efficient markets" has almost
certainly destroyed the opportunity.
The best example of how powerful a force is market efficiency is
the story of the most famous (and infamous) hedge fund, Long Term
Capital Management. The firm was founded by some of the brightest stars
on Wall Street, and it attracted some of the top minds in academia,
including two Nobel Laureates. The firm¹s strategy was to exploit market
anomalies.
Unfortunately, the tyranny of the efficient markets (as well
as their own hubris) overwhelmed all the assembled brainpower. Investors
lost billions of dollars. The failure of the fund even threatened the
global financial system. Eventually the Federal Reserve, under Alan
Greenspan, negotiated a lender bailout that allowed for an orderly
unwinding of the fund.
There are three lessons for investors. The first, as Rex
Sinquefield, co-chairman of Dimensional Fund Advisors, points out is:
"Just because there are some investors smarter than others, that
advantage will not show up. The market is too vast and too
informationally efficient."
The second is that by the time you can
identify a hedge fund that can exploit an anomaly it has likely
disappeared.
The third lesson is that while the exclusive nature of the
club appeals to many, investors would be best served to recall Groucho
Marx's line: "I wouldn't belong to any club that would have me as a
member."
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