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Romancing Alpha, Forsaking Beta

The High Cost of Chasing Performance


Presentation by Barry Ritholtz The Big Picture Conference, October 8, 2013 McGraw-Hill Auditorium, NYC

How Does Your Brain Interfere With Your Investing?


Behavioral Economics
1. Herding, Groupthink 2. Experts: Articulate Incompetents 3. Optimism Bias 4. Confirmation Bias 5. Recency Effect 6. Emotions impact perception

Neuro-Finance
7. Anticipation vs. Rewards 8. Selective Perception & Retention 9. A Species of Dopamine Addicts 10. Endowment Effect of Ownership 11. Monkeys Love a Narrative 12. Cognitive Errors Impact Processes

This is your brain on stocks

Looking at Alternative Investments

What Dont You Know About Hedge Fund Investing


Some Surprising Hedge Fund Info 1. Hedge Funds manage ~1% of total financial assets (Yet capture an disproportionate amount of media mindshare). 2. Hedge fund 2&20% fees exert enormous drag on returns; 3. Total Asset Weighted Alpha generated by tiny % of managers (Non Gaussian Dispersion = Fat head/Long tail) 4. Many funds start out creating Alpha but morph into fee capture 5. Picking new & emerging managers is exceedingly difficult; (Your biases make the process even harder)

Hedge Funds = 1.1% All Financial Assets

Global hedge fund industry = $2.13T Given what a relatively small asset class this is, they receive an excess of media attention. Perhaps because so many hedge fund managers have become billionaires, they have captured the investing publics imaginations

HFRX Global Hedge Fund Index Performance Data


How Have Hedge Funds Done?
2012 = Returns equaled 3.5% versus S&P 500-stock index 16% 2007-12 = Lost 13.6% vs. S&P 500-stock +8.6% 2013 = Gained 4.52% YTD vs. S&P 500-stock +14.5% YTD

Source: WSJ, HFRX

Diminishing Hedge Fund Returns

Alpha has diminishing returns to scale because many strategies only apply to smaller stocks and/or prices move against managers if they try to execute trades that are too large. Source: WSJ

Hedge Fund Growth

1997 = $118 billion 2012 = $2.04 trillion.

1. 2. 3.

Talent Dilution Excess Size Correlation / Indexers

Optimism Bias at Work


The Daunting Math of Mutual Fund Manager Selection
1.Only 20% of active managers (1 in 5) can outperform their benchmarks in any given year; 2.Within that quintile, less than half (1 in 10) outperform in two out of the next three years; 3.Only 3% stayed in the top 20% over five years (1 in 33) 4.Once we include costs and fees, less than 1% (1 in 100) manage to outperform (net). 5.What are the odds you can pick that 1 in 100 manager?
Sources: Morningstar, Vanguard

Confirmation Bias in Action

56% said they invested in hedge funds for diversification purposes Hedge funds correlated with other vehicles, falling in crisis Is Your Original Investing theme valid? 81% of investors said Yes (as of 2009)

Is This Rational Investing?


Managers Capture Investment Profits Mostly For Themselves
From 1998-2010 hedge fund managers earned $379 billion in fees. The investors in their funds earned only $70 billion in investing gains. Managers kept 84% of investment profits, investors netted 16%. As many as 1/3 of hedge funds use feeder and/or fund of funds. This brings the industry fee total to $440 billion thats 98% of capture. Investors are left with $9 billion dollars merely 2%.
Source: Simon Lack, The Hedge Fund Mirage

Who Profits from Hedge Funds?

Source: Hedge Fund Mirage.via Falkenblog

Hedge Fund Manager Profit Capture

Does not include Survivorship Bias, self reporting. Assume +3%

Who Profits from Hedge Funds?

Source: Hedge Fund Mirage.via Falkenblog

Two Smart Guys


2 smart guys leave Goldman Sachs to set up a hedge fund; They raise $1 billion dollars: Performance: Year 1: +15% Year 2: +10% Year 3: -5% , (return capital) Earnings (2 + 20%): Year 1: $20m + $30m Year 2: $22m + $22m Year 3: $24m + $0 Total Comp = $118m (Total S&P500+Div=17%) (S&P500 = 14%) (S&P500 = 12%)

Comparable Compensation

Source: Forbes

Top Hedge Fund Manager Compensation (Hourly)

It takes the average family 18.5 years to make what these hedge fund managers make in 1 hour

Source: Forbes

How Does Your Brain Interfere With Your Investing?


Behavioral Economics
1. Herding, Groupthink 2. Experts: Articulate Incompetents 3. Optimism Bias 4. Confirmation Bias 5. Recency Effect 6. Emotions impact perception

Neuro-Finance
7. Anticipation vs. Rewards 8. Selective Perception & Retention 9. A Species of Dopamine Addicts 10. Endowment Effect of Ownership 11. Monkeys Love a Narrative 12. Cognitive Errors Impact Processes

What Should Investors Do ?


Understand What You Can and Cannot Do Well As Managers -How overweight in alt (PE/HF/VC) investments are you? -Focus on Asset Allocation (15 distinct classes) -Use Core & Satellite Approach to Reduce Temptations -Take Advantage of Mean Reversion via class rebalancing -Lower your expectations until the next 1982 comes along -Think longer term -Get Unsexy!

We have met the enemy, and he is us. -Walt Kelly, Pogo, 1971

Supplemental Materials

Paulson Hedge Fund


Manager Selection is Much Harder Than People Believe -John Paulson launched his hedge fund in 1994 -Hires Paulo Pellgrini in 2004 -Raised $147 million in 2006 for Subprime Bet -Greatest Trade Ever in 2006-07 -Assets under management had swelled to $36 billion. -Subsequent losses were 52% in one fund, 35% in another.

Pellegrini PSQR Hedge Fund


Manager Selection is Much Harder Than People Believe
Paulson gave Pellegrini a $175 million bonus . . . Response: F#$% you, I quit Formed PSQR in 2008 Returns: 2008 = 40% 2009 = 61.6% 2010 = -11% August 2010, Pellegrini returned all outside investor capital
Sources: Greg Zuckerman, The Greatest Trade, WSJ

Hedge Fund Attrition


When a fund leaves the Lipper TASS database or stops repor7ng, the database lists one of the following as the possible reason:
Fund closed to new investment. Fund dormant. Fund has merged into another en7ty. Fund liquidated. Fund no longer repor7ng. Program closed. Unable to contact fund. Unknown.

92% of funds that leave the database are assigned to just three of the 8 reasons: fund liquidated (36%), fund no longer repor7ng (38%), and unable to contact fund(18%) If a fund leaves the database because it liquidated, it is safe to assume that the decision was based largely on poor performance The aPri7on for funds that reported returns for the month of December 2006 (which covers the 24 months through 2008) is alarmingly high- 29% to 63% of the funds seem to have disappeared Based on these aPri7on rates, one can expect anywhere from 20% to 60% of the funds repor7ng at any given 7me not to last through the next 24 months Such high aPri7on rates can have serious consequences for long-term investors Vanguard also reports the average annualized excess returns of the funds that disappear. The excess return is calculated with respect to the peers in the hedge fund categories
Source: hPps://www.vanguardinvestments.se/content/documents/Ar7cles/Insights/alt-vs-indexing.pdf

Underperformance: The majority of funds sixty-two out of 100 failed to exceed returns available from the public markets, a\er fees and carry were paid. There is not consistent evidence of a J-curve in venture inves7ng since 1997; the typical Kauman Founda7on venture fund reported peak internal rate of return (IRRs) and investment mul7ples early in the funds life. The cumula7ve eect of fees, carry, and the uneven nature of venture inves7ng ul7mately le\ us with sixty-nine funds (78 percent) that did not achieve returns sucient to reward us for pa7ent, expensive, long-term inves7ng. (hPp://www.kauman.org/uploadedFiles/vc-enemy-is-us-report.pdf) A report by the Na7onal Venture Capital Associa7on (NVCA) states that, It is interes7ng to note that 2012 is the rst post-bubble year in which venture funds collec7vely distributed more cash to limited partners than they brought in. (hPp://www.prweb.com/releases/2013/5/prweb10770077.htm)

(http://smullaney.com/wp-content/uploads/2010/12/VC-Performance1.jpg)

Outperformance: Bain & Co. in their 2013 Global Private Equity Report claim that, despite falling returns (above) and increased volatility (top right), buyout funds still outperformed the S&P 500 (right).

Emotions & the Sentiment Cycle

Source: Ritholtz.com

for more information, please contact

Barry L. Ritholtz
Ritholtz Wealth Management 90 Park Avenue, 18th Floor New York, NY 10016 212-455-9122 Info@Ritholtzwealth.com