24 December 2019
Sell Hedge Funds – Buy Lego
Seeking uncorrelated consistent returns.
By Frank O’Nomics
One of the main attractions of putting money into hedge funds is that they can, along with other “alternative” investments, (supposedly) deliver returns that are uncorrelated with long only investments in conventional asset classes. It is not surprising then that 2018 saw widespread disappointment in the poor returns delivered by hedge funds, which offered little offset to the sell off in equities and bonds. Does this call into question the validity of hedge fund investments? If so, where can we look for consistent returns that are not correlated with the main asset classes? One answer, which will surprise many, is the children’s toy firm Lego. While I would not even begin to advocate making Lego a major part of an investment portfolio, a performance comparison with hedge funds may be a sobering process for the managers who have made so many millions (for themselves) over the last few years.
In 2018 6 out of 10 hedge funds lost money, the highest proportion since 2018. While there was a wide dispersion of returns, on average the loss was 5%, with over 40% of funds losing more. This loss compares with an average return of 8.5% in 2017. You might argue that, taken over the two years, a net profit is not so bad. However, when you look at the S&P total return, which was over 21% in 2017 and only lost 4.4% in 2018, it looks much less clever. In short, hedge funds have underperformed in both a rising and falling market. Not surprisingly there was a wave of closures, with 3 US funds closing in one week alone in October. Money flowed out in a torrent, particularly in Europe, where outflows amounted to $12.8bn compared with inflows of $28.9bn in 2017, as investors sought safer havens.
In looking at the causes of the underperformance it soon becomes clear that the outcome is very different depending on the type of strategy and the type of manager. Not surprisingly it was equity hedge funds that suffered most, while some of those that focused on fixed income and contrarian strategies, such as Brevan Howard and North Asset Management, had a much better experience. Part of the problem is that there are just too many hedge funds producing average returns, but there also seems to be an issue with a move from discretionary strategies controlled by humans, to systematic strategies driven by black box computer programmes. Both of these strategies suffered in the March and October equity meltdowns, but over the year active managers like Crispin Odey, who returned a whopping 60%, generated some of the better performances.
There is then a wide disparity in performance across funds, but in total the experience has been disappointing. So what about Lego? A recent study by Victoria Dobrynskaya at Russia’s Higher School of Economics has demonstrated that a collection of Lego returned more than large stock, bonds and gold over a three-decade period to 2015. The returns even compare well to so-called “smart beta” funds that look to deliver a smooth level of outperformance. The study looked at 2,300 Lego sets sold between 1987 and 2015 and showed an 11% per annum return. What is key is that the returns do not show a significant correlation to financial crises and demonstrated an encouraging diversification potential. There is even scope to adopt a “smart” approach to Lego investing, with smaller sets delivering better returns than larger ones, newer sets returning more than old ones, with those focusing on Super Heroes doing best over time. The only theme to lose value (3.5% on average) has been the Simpsons.
Many academics will argue that, if you look around hard enough, you will be able to find something that will produce uncorrelated returns for long periods of time, but that this is pure happenstance. Others will cite Goodhart’s law, which states that, when a measure becomes a target, it ceases to be a good measure – and if investors, rather than collectors, focused on Lego, all sorts of shifts in supply and demand dynamics would start to occur. Lego is, when all said and done, merely a toy and it is unlikely that we will be saying: “No darling, you can’t play with that, its daddy’s pension”, any time soon. Although at least if it all went pear-shaped you would still have both a physical testament to your folly (rather than just an empty bank account) and a toy to play with.
The point here is not to suggest an alternative to hedge funds, but to provide another way of illustrating that overall they are a part of the investment industry which is not delivering what it sets out to. Just as with conventional investments the choice is whether to go with an active manager or a computer driven model. Higher uncorrelated returns will be delivered by active hedge funds, but with a much greater risk. In addition, the costs of such investments are very high, with the manager charging 2% per annum, plus 20% of the funds performance above it’s “hurdle rate”. This may make being a hedge fund manager much more attractive than being a hedge fund investor. One such manager was this week able to find £100mn to buy a property close to Buckingham Palace. Does he have a room set aside for his Lego? Nice work if you can get it.
