Why don’t most hedge funds beat the market?

I often write on Quora.com, where I am the most viewed writer on financial matters, with over 383.8 million views in recent years.

In the answers below I focused on the following topics and issues:

  • Why don’t most hedge funds beat the market?
  • Why can stocks be so volatile?
  • How do you protect your wealth?
  • What is the difference between wealth and income?
  • How reliable is the Forbes rich list?

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Some of the links and videos referred to might only be available on the original answers. 

Source for all answers – Adam Fayed’s Quora page.

Why don’t most hedge funds beat the market?

The main reasons are:

  • The fees can be 2% + a 20% performance fee in some cases.
  • It isn’t their aim to beat the market in most cases. Often they are trying to control the risk-adjusted returns. Moreover, as many good advisors operate under a core and satellite approach, often hedge funds are only allocated at 10%-20% of a total portfolio.

For a minority of hedge funds, they do feel that they can beat the market.

One hedge fund owner had an ill-fated bet with Warren Buffett that they would beat the S&P500 over a ten-year period.

He lost as the video below explains

With that being said, there is a third reason for the underperformance- size.

The top ten hedge funds have a large percentage of the total market:

We know they haven’t beaten the market, at least over a long period of time, but most hedge funds are smaller.

It is more difficult to beat the market with a larger hedge fund, than a smaller one.

Getting a great return from a $50 million mandate is easier than a 20billion one, because it is more difficult to find as many opportunities to put large amounts of money to work.

Even Buffett admits that he would be confident to beat the market with $10million but not billions under management.

The same is true for actively managed funds. It is much more difficult to beat the market with larger amounts.

So, the best hedge funds are actually boutique. The problem is, the best-performing smaller hedge funds might become a victim of their own success.

In other words, over-performance results in massive inflows, and then the great performance ends.

Why is the stock market so volatile (changes in a fraction of second)?

Remember when Tesla’s stock fell on an Elon Musk tweet?

The stock fell 11% after that:

Remember too when Coca Cola’s stock fell after Cristiano Ronaldo “threw away” the coke bottle on live TV and encouraged people to drink water instead?

There are two things to remember here:

  • The short-term
  • The long-term

The short-term is dominated by speculators speculating about what other speculators are speculating about.

Stocks, and other assets, can go up (or down) by factors that don’t influence the fundamentals, due to human emotions.

Coka wasn’t less valuable, long-term, after Ronaldo’s actions. Nor was Tesla.

In the long-term, stocks are dependent on two factors:

  • Earnings growth
  • Dividends.

So, there are two returns – the speculative and the real investment return.

Over almost any 30–40 year period, what matters is the investment return.

For example, from the early 80s until the early 2000s, the total return of the US stock market was almost identical to the dividend yield and earnings growth of the firms.

In the middle, however, there was speculation. Stocks went up too much above their fundamentals between 82–00 and didn’t go up as much as they should have before 82.

Things eventually even out. The point is, to be an investor, not a speculator.

There is little point in trying to profit from short-term trading or getting afraid of volatility.

Volatility isn’t risky provided you play the long game and don’t care about the noise.

How does one protect one’s wealth?

It is a great question, because protecting and preserving is different to accumulating.

Below is a list

  1. Put cash to use

Any retirement calculators which look at putting your money in stocks, cash and bonds show a clear commonality – your money will run out in cash.

Even if you avoid a currency crisis like what has happened recently in Turkey and Russia, compounded inflation will erode your money.

This calculator tells its own story.

As does this statistic.

2. Don’t put all your eggs in one basket.

We have all heard the old adage not to put all your eggs in one basket.

Concentration is highly risky but can build your wealth. Many super-wealthy people have built a company, and either sold or kept taking a dividend from it.

However, having all your eggs in one asset class, business, currency or market is very risky.

If you are looking to preserve your wealth, the name of the game shouldn’t be just to get the highest possible return.

The objective should be to get the best possible risk-adjusted return, whilst protecting the downside.

That doesn’t mean being overly cautious, but it does mean being sensible.

3. Be careful with debt and liquidity

Not all debt is bad, and many wealthier people use it to increase wealth.

Typically, debt is used most effectively with illiquid assets like buy-to-let properties and a business, but it is risky.

You face two risks – that you can’t sell the assets and the leverage/debt becomes excess.

This needs to be controlled.

4. Have your ducks in a row

Nobody likes paying lawyers, accountants, or trust fees. Few people find buying insurance interesting either.

However, it can be a necessary evil to protect wealth, legally reduce taxes, and more easily leave assets to the next generation.

The latter point is especially important for expats who might be dealing with multiple jurisdictions.

Things like expat wills aren’t as simple as some people imply.

What is the difference between wealth and income?

Let me illustrate with a few examples.

This is Alan Sugar – he has an estimated net worth of 1.2 billion UK Pound Sterling, and hosts the UK version of the apprentice:

He paid himself a dividend of £390M recently. That was one of the biggest paydays in UK history.

Denise Coates paid herself an even bigger dividend, at 421m. She is worth about $12.2 billion according to online sources.

Now here is the interesting thing. Sugar dividends in particular would, most likely, surprise many people.

It seems very high compared to his total net worth, and is far bigger, as an income, than some people who have $100billion of net worth on paper.

The reason is simple. He owns cash flow-producing assets like property. The focus is on dividends rather than capital appreciation.

In comparison, if somebody has done an IPO, their net worth is linked to the stock market performance.

In other words, it is completely fluctuating, and having X and Y billion, doesn’t mean they have as high an income as these two people are able to take.

Net wealth is merely focused on calculating the total assets a person has, merely income is what is being paid out.

Think about two different property investors. They both have a million held in different properties.

The first person is making 80,000 a year from income, but the property values are stagnant, whereas the second person is “making” 10% a year from the buildings going up in price, with low dividends of 20,000 a year.

On paper, the second person’s wealth is going up more quickly, but they aren’t getting a good income from the project, and need to sell out to realize the profits.

Especially when it comes to illiquid assets like land, property, and unlisted businesses which aren’t on the stock market, what the asset is producing is more vital than capital appreciation.

I have met many a person who has owned land which has gained in value, but then they can’t find a buyer or earn much yield from it.

How reliable is Forbes’ list of world billionaires? What metrics were applied to come up with that list?

It is fairly accurate when it comes to people who have listed companies.

You can estimate Bezos’ wealth based on Amazon’s share price today + some of his other investments.

It gets more tricky when it comes to dictators and people who live in countries with little transparency.

There is reasonable evidence that Kim Jung Un, Putin, and several others should be on the rich list.

It is impossible to prove though, as the money can’t be ascertained, and much of it most likely is held in other people’s names.

So, Forbes is a good list in terms of verifiable wealth.

Beyond that, Forbes doesn’t account for two things:

  1. Family wealth

It is a list of individuals.

It doesn’t account for family wealth. For example, the House of Saud has over a trillion in wealth, even if no individual has that.

2. Income versus wealth

This one sounds obvious. It is a “wealth list” and not an “income list” after all.

Yet many people do lack common sense when it comes to the list. The assumptions most people make are:

  • If somebody has billions, they can spend it.
  • A lot of the wealth is liquid. Therefore, if somebody has 100billion as an estimated net worth figure, they can easily spend 50billion. In reality, a lot of this money might be held in businesses, real estate, private investments, etc
  • If somebody is higher up on the list, they can spend more. Let’s look at this in another way. Could Elon Musk spend $1billion every year for the rest of his life? Maybe, but very unlikely, because he would need to keep selling off Tesla’s stock, and hope it keeps rising. In comparison, members of royal families have the whole country’s wealth behind them.

The latter point is one reason why whenever you hear about the sale of a painting for hundreds of millions, it tends to be an absolute monarch in the Middle East (or beyond) buying it, and not a billionaire who runs a company.

The point is, saying X and Y person is richer than the Queen or MBS, is misleading.

It isn’t comparing apples with apples.

Pained by financial indecision? Want to invest with Adam?

Financial Planner - Adam Fayed

Adam is an internationally recognised author on financial matters, with over 623.1 million answer views on Quora.com, a widely sold book on Amazon, and a contributor on Forbes.

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