Friday, March 20, 2015

Kill your investing gurus: billionaire hedge-fund managers

Many of today's most successful hedge-fund managers are open about their investments and investing strategies. They write detailed investor letters, they give television interviews, et cetera. Additionally, large funds are required to make 13F-HR filings with the SEC that list the American stocks they own. Understandably, these letters, interviews, and 13Fs attract a lot of attention. People read them hoping to find good stock picks or learn new ideas about investing.

This post argues that following top hedge-fund managers is mostly a waste of time. Specifically, it argues that:

• Most elite hedge-fund managers aren't singular geniuses. They're above-average investors who have benefited from being in the right environment for their investing strategy.
• For every fund manager who's become really rich, there are many others who have used the same strategy but are much less rich. Skill isn't necessarily what separates the richest from the rest.
• Some elite fund managers owe their reputations to shrewd marketing rather than shrewd investing. Some of them have gotten rich by charging high fees for mediocre performance.
• Over the past 15-20 years, the hedge-fund industry has grown exponentially. This constant influx of new money into hedge funds has artificially raised their aggregate returns.

Environment versus skill

A couple weeks ago, I wrote a post about Dan Loeb's early career. It described the kinds of investments he made in the late 1990s and early 2000s, before he and his fund became well-known. One thing the post didn't mention is that Loeb and David Einhorn had numerous overlapping investments during that period.

Loeb wrote about many of his investments on public message boards, and the first chapter of Einhorn's book Fooling Some of the People All of the Time describes his experiences during the 1990s. Between their writing and their 13Fs, we have a good sense of how they invested, and it was often the same: They each invested in Summit Insurance Holdings and Consolidated Freightways. They each lost money on Reliance Acceptance. They each made Agribrands their largest investment in 1998. They each shorted Computer Learning Centers, Conseco, and Sirrom. They each acquired more than 5% of Stage Stores in 2001 when it emerged from bankruptcy.

Einhorn's 13F filing from November 12, 1999 shows 22 investments worth at least $1 million. 10 of those 22 were stocks that Loeb owned at the time or had owned previously. The overlap was even greater for their favorite stocks: Einhorn's largest and second-largest investments were Loeb's largest and third-largest, respectively, at the time.

This overlap in individual stocks reflected a shared philosophy: both Loeb and Einhorn specialized in making the kinds of niche investments that Joel Greenblatt described in You Can Be a Stock Market Genius: spinoffs, demutualizations, companies emerging from bankruptcy, etc. Loeb recommended Greenblatt's book in numerous message-board posts. Einhorn has also recommended it.

Today Loeb and Einhorn own few of the same stocks, but their careers have nonetheless followed the same trajectory. They've experienced similar growth in assets under management, they've both set up reinsurance companies, and their funds have both underperformed the S&P 500 in recent years.

Since these guys are billionaires, it's tempting to assume that they must be uniquely talented. But the similarity between their investments and investing strategy-- a similarity that was particularly strong in the late '90s, when they earned their highest returns-- suggests otherwise.

That doesn't mean they aren't skilled investors: they were both savvy enough to realize that special situations were a great, undiscovered opportunity. But it was this opportunity, rather that unique skill on their part, that let them beat the market so handily.

The richest investors aren't necessarily the best

Not every talented investor cares about making as much money as possible. Some are willing to grind away in order to become multi-billionaires, but others are content to retire with $25 million and enjoy the good life. For every hedge-fund billionaire, there's probably an equally talented investor who cared less about money than spending time with his family, traveling the world, or something else. Warren Buffett and Ben Graham illustrate this contrast:

What made Graham a lot of money was realizing that convertible bonds and preferred stocks carried a valuable option that was often undervalued, and so he would buy the convertible security and short common against it.  Strategies like this, plus activist investing, where he uncovered information advantages on undervalued stocks allowed him to become wealthy.

And that was enough for him.  Unlike his more focused protege, Warren Buffett, once the game got too tough, and a pleasant retirement was attractive, he trotted into the sunset...

Joel Greenblatt pioneered the style of investing that made Einhorn and Loeb famous, but his hedge fund peaked at $500 million in assets, whereas they each manage a fund worth more than $10 billion. Presumably his personal wealth is also much less.

Sometimes the richest investors get that way by being aggressive rather than thoughtful. I've written before about KKR and Wesray, which were two of the most prominent private-equity firms in the 1980s. Wesray made fewer acquisitions in the late '80s as valuations rose, while KKR was always eager to do bigger deals at higher valuations. Wesray's leveraged buyouts performed better than KKR's buyouts, but KKR's principals are richer because they used leverage more aggressively during a long period of rising asset prices and falling interest rates.

Getting rich off fees and marketing

The backward-looking attitude of hedge-fund investors has helped make a lot of fund managers rich. Loeb and Einhorn have earned large performance fees in the past few years as their funds have underperformed the S&P 500. Investors have been willing to pay them these fees because of the historical returns that they earned on much smaller amounts of money in a much less competitive environment.

Many top fund managers also owe their success to shrewd marketing, specifically their ability to be promotional without seeming promotional. An Economist profile of Seth Klarman illustrates this, claiming that he stays out of the spotlight while shining one on him:

Soft-spoken and based in Boston, a safe distance from the Wall Street mêlée, Mr Klarman keeps a low profile and rarely speaks at industry shindigs. He is probably the most successful long-term performer in the hedge-fund industry who has managed to stay out of the spotlight.

Klarman also made a shrewd move when he let Margin of Safety go out of print. Used copies now fetch $2000 on Internet auction sites, and this has contributed to perception that he's a value-investing legend. In reality, both the book and his returns are good but not phenomenal.

Einhorn's public crusade against Allied Capital lets him portray himself as a thoughtful, methodical investor who exemplifies integrity.

Howard Marks has his widely-circulated memos, which state what every sophisticated investor already knows but state it so eloquently that people feel like they're learning something new. As expositions on investing, the memos are mundane. As marketing aids, they're brilliant.

The hedge-fund industry is a Ponzi analogue

I believe that hedge funds are an example of what Robert Shiller calls "naturally occurring Ponzi processes." A Ponzi process happens when an investment's performance depends on continuous inflows, without which its price will fall. Initially, inflows cause an investment to appreciate. This encourages more inflows, which cause further appreciation, and so on.

In 1998, hedge funds had $140 billion of assets under management, and a large chunk of that was in two macro funds. Today the industry has more than $3 trillion in AUM.

As hedge funds have prospered and received more money, they've poured it into many of the same investments that originally made them successful. In the aggregate, the industry has invested increasing amounts of money into spinoffs, distressed debt, industry-consolidation plays, etc.

In his Inside the House of Money interview, Scott Bessent describes what happens when more and more money is thrown at the same investments:

[I was] short a Janus stock during the Internet bubble. There was this fund called the Janus 20 and the only reason the stocks went up was because of asset inflows. The mutual fund was taking in $50 million a day and they just kept jamming it into those 20 stocks.

The hedge-fund industry's experience over the past fifteen years has been Janus 20 writ large. While top hedge funds are more sophisticated than a bubble-era mutual fund, the basic dynamic is the same.

Some fund managers like Julian Robertson and George Soros have invested for decades and made money in numerous market environments. It's safe to say that their returns are skill rather than luck. The fund managers who have risen to prominence in the past 15 years have only experienced a single market environment, one that has been extremely favorable for them. If they had to invest with stable or shrinking AUM, their alpha would probably disappear.


  1. I recently found your site, and am going through your archives. You have some really nice and interesting content out there.

    1. Thanks, I'm glad it's of interest.


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