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On hedge fund marketing and gaslighting.
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In 1821, a man named William Hart dug the first natural gas well in the United States on the banks of Canadaway Creek in my hometown of Fredonia, New York. The well was 27 feet deep, was excavated by hand using shovels, and its gas pipeline consisted of hollowed out logs sealed with tar and rags. Natural gas was soon transported to businesses and street lights in town. These lights frequently attracted travelers, often causing them to make a significant detour to see this new wonder. Expanding on Hart’s work, the Fredonia Gas Light Company was formed in 1858, becoming the first American natural gas company.
Gas lighting is thus an inexorable part of my personal history. But I’m more interested in gaslighting.
Merriam-Webster, the dictionary people, announced its 2022 word of the year last week: gaslighting, a “word for our time.” The selection of the term – defined as “the act or practice of grossly misleading someone, especially for one’s own advantage” – was in part a response to public interest. Searches for “gaslighting” rose by 1,740 percent over the past 12 months.
The concept has a precise origin story. In the 1938 play, Gaslight, a murderous husband is intent on inducing instability in his wife in order to accommodate his venality. When she notices that he has dimmed the gaslights in their house, he tells her she is imagining things – that they are as bright as ever – to get her to question her senses and her sanity.
The British play became a classic 1944 American film from George Cukor, starring Ingrid Bergman as the heroine and Charles Boyer as her abusive husband, out to convince her that reality is not what she perceives.
In this sort of story, our most dangerous enemies are often those closest to us, masquerading as lovers and friends. Gaslight reminds us how uniquely terrifying it can be to mistrust the evidence of our senses and of what we know to be true.
Taking off from the film, “gaslighting“ in contemporary usage has come to mean a form of intimidation or psychological abuse whereby false information is systematically presented to the victim in such a way as to cause him to doubt his own memory, perception, or even his sanity. As in the movie, gaslighting is a hallmark of domestic abuse, but one can see its use and impact almost everywhere.
American politics is perhaps ground zero for gaslighting worldwide. For example, a would-be leader can propose the “termination” of the U.S. Constitution – which leaders swear a duty to preserve, protect, and defend – then deny he would ever claim such a thing, and have supportive politicians falling all over themselves to pretend it didn’t happen or doesn’t matter. Or, for example, major media and tech platforms can call a major news story “disinformation,” bury it en masse and, when the underlying facts of the story can no longer be denied, insist it’s “nothing new” and unimportant.
Gaslighting is a staple of finance, too.
In the investment management world, the overarching priority for money managers is to gather assets and revenues and only peripherally to provide quality performance for investors. Gaslighting is routinely used to try to obscure those priorities and to convince investors that, despite the reality of what they see, investing in product x or with firm y is a smashingly good idea.
To be sure, money managers do indeed want very much for their strategies, funds, and investment approaches to succeed. Good investment performance makes growing assets and revenues much easier, after all, and improves client “stickiness” enormously. But that isn’t the top priority – not by a long shot. Never mistake what investment management marketing says (or implies) with truth.
Hedge funds are the obvious low-hanging fruit when looking for gaslighting in finance. As Victor Fleischer famously put it, “hedge funds are a compensation scheme masquerading as an asset class.” The first hedge fund was founded in 1949, but as they became ubiquitous, the standard pitch (I was in an early pitch meeting for the ill-fated Long-Term Capital Management in late 1993) generally focused on outsized returns that promised more than enough juice to justify the exceedingly large concomitant fees.
But it’s all gaslighting. Performance hasn’t remotely lived up to the hype. After some fabulous early performance (with wild risks), LTCM spectacularly blew up in 1998 – and I was there to watch the bid lists flow in via fax to the cavernous Merrill Lynch fixed income trading floor as the firm began to give up the ghost.
Gaslighting and poor performance undergird the change in hedge fund marketing over the years. It went from “We’re going to make a ton of money,” to “We’re going to outperform,” to “We’re going to provide superior risk-adjusted returns,” to “We’re going to provide absolute returns even in down markets,” to “We’re going to provide non-correlated returns.”
None of those claims has turned out to be generally true and, yet, hedge fund marketers act like they are true and, even worse, pretend the pitch has never changed. These pitches try to say that the lousy performance we see isn’t the performance that matters.
At the Berkshire Hathaway 2007 shareholder meeting, Warren Buffett offered to bet any taker $1 million that, over ten years and after fees, the performance of an S&P 500 index fund would beat a collection of hedge funds that the opponent might choose. As Buffett wrote later, “I then sat back and waited expectantly for a parade of fund managers ... to come forth and defend their occupation. After all, these managers urged others to bet billions on their abilities. Why should they fear putting a little of their own money on the line?”
Spoiler alert: There was no parade, which gave the game away right from the get-go.
Ted Seides of Protégé Partners, which oversees funds-of-hedge-funds, rose to the challenge, the only one with guts enough to do so (which, duh, proves the gaslighting). Protégé hoped to demonstrate that “funds of funds with the ability to sort the wheat from the chaff [would] earn returns that amply compensate for the extra layer of fees their clients pay.” Winnings from the bet would be donated to a charity of the winner’s choice.
The wager began on January 1, 2008 and concluded ten years later. The S&P 500 fell about 50 percent in the first 14 months of the bet but came back strongly thereafter to win big. By the end of the bet on December 31, 2017, the S&P 500 fund had returned 7.1 percent annualized (about 99% overall return) versus just 2.2 percent annualized (about 24% total) for the basket of hedge funds Seides had selected. Buffett won so decisively that Seides conceded long before the end of the bet.
That background goes a long way towards explaining Buffett’s comments at the next Berkshire Hathaway annual meeting. “It might sound like a terrible result for hedge funds but not a terrible result for hedge fund managers,” Buffett said. Although it’s not so prevalent now, largely on account of the poor performance I’m highlighting, hedge funds have generally tried to charge a management fee of two percent of assets plus 20 percent of any profits.
“There’s been far, far, far more money made by people in Wall Street through salesmanship abilities than through investment abilities,” Buffett noted.
Explaining why he lost, Seides noted that the MSCI All Country World Index almost exactly matched hedge-fund returns during the bet, claiming it “isn’t a perfect benchmark for hedge funds either, but it is a lot closer to an apples-to-apples comparison than hedge funds and the S&P 500.” He isn’t wrong in the sense that, for the selected period, the S&P’s performance was superior to other asset classes. However, he is wrong within the context of how hedge funds were initially marketed – to make a boatload of money. Indeed, if the managers were as smart as they claimed, a hedge fund that can invest anywhere ought to invest in great places.
Even the top 50 hedge funds (based on their net annualized five-year returns) collectively trailed the S&P 500 over the five years that ended in 2021 (survivorship bias makes the actual results even worse than they appear). They still lagged by “just” 3 percentage points but, consistent with the newer marketing approaches, emphasize they do so with less risk and little correlation with the broader market.
Clearly, nobody should be using hedge funds for expected outperformance.
When analyzed on an asset-weighted basis, hedge fund returns are even worse than the chart above shows (which is really bad), as smaller funds, more able to avoid crowded trades, generally outperform. As Simon Lack documented in his book, The Hedge Fund Mirage, if all the money that has ever been invested in hedge funds had been invested in U.S. Treasury bills instead, the overall results would have been twice as good.
That failure – and it is a monumental failure – is largely on account of outsized fees (as noted above). The notorious “two and 20” makes realizing the outsized gains hedge fund investors typically expect essentially impossible to obtain in the aggregate, despite a handful of prominent success stories. Indeed, the hedge fund industry retained in fees 84 percent of the total dollar profits generated from invested capital, leaving just 16 percent for investors. Including fees charged by fund-of-funds like Protégé Partners (to whom nearly half of hedge fund investors delegate fund selection and portfolio construction), the share “enjoyed” by investors fell to just 2 percent.
Every year in New York City, the Sohn Investment Conference is a really big deal. It’s perhaps the premier hedge fund conference. Lots of big-names share what purport to be their best ideas. However, the performance of even those “best” ideas has been generally lousy (see here, for example).
Few investors of any sort should find that good enough. No retail investor should.
The full body of available evidence compellingly shows that hedge funds haven’t lived up to the more nuanced recent hype either. Indeed, hedge fund promises far outpace performance – by any measure. “Despite promises of better and less correlated returns, hedge funds failed to deliver significant benefits to any of the pension funds we reviewed,” one prominent study found.
“Our analysis suggests that hedge funds as an investment product fall short of both of their major selling points: outsized returns that offset the exorbitant fees and uncorrelated returns that smooth out market volatility and offer investors protection during economic downturns.”
According to an important 2010 Ibbotson study, gross of fees, the annual hedge fund return to investors over the period from 1995 to 2009 was 11.42 percent, before falling off a cliff with the financial crisis. Pre-crisis, hedge funds created significant alpha and risk-adjusted returns. However, management and performance fees reduced this figure by 3.79 percentage points and thus to much less than the S&P offered.
Therefore, even when hedge funds were generating decent alpha, they kept nearly all of it for themselves. Very few real live investors achieved even the average results claimed because they are distorted by the initial strong performances hedge funds enjoyed when the industry was far smaller. These flaws don’t even speak to the general lack of transparency from hedge funds and the lack of liquidity provided by hedge fund investments.
Good trades get crowded and their advantages tend to disappear. This crowding happens because success begets copycats as investors chase returns. Mean reversion only tends to make matters worse. In effect, it results in “investing while looking in the rear-view mirror.” Now that trillions of dollars are invested in hedge funds, there is no reason to think that the halcyon days – if they ever existed – will return.
The late David Swensen, long-time head of the Yale Endowment, long insisted that few will have access to first-rate hedge funds even if and when it is possible to predict in advance which of them are truly first-rate. In his book, Unconventional Success, Swensen provided some cautionary advice.
“In the hedge fund world, superior active management constitutes a rare commodity. Assuming that active managers of hedge funds achieve success levels similar to active managers of traditional marketable securities, investors in hedge funds face dramatically higher levels of prospective failure due to the materially higher levels of fees.”
As for funds of hedge funds, Swensen called them “a cancer on the institutional-investor world” and said they “facilitate the flow of ignorant capital.”
There is another – implicit – reason investors use hedge funds, and it has nothing to do with performance. It is crucial to the hedge fund mystique and supported by major charitable giving, hedge fund manager prominence in the society pages, and even the Showtime television hit, Billions.
Meir Statman of Santa Clara University provided this added explanation.
“Investments are like jobs, and their benefits extend beyond money. Investments express parts of our identity, whether that of a trader, a gold accumulator, or a fan of hedge funds.”
He then explained that people frequently invest in hedge funds for the same reason they buy a Rolex – they are expressions of status available only to the wealthy. This status is fundamental to hedge fund allure despite dreadful performance, and hedge fund marketing takes full advantage.
As Chris Brightman of Research Affiliates likes to say, echoing Groucho Marx, “The hedge funds that produce [great] results will never manage your money.” And, as Nobel laureate Eugene Fama noted: “If you want to invest in something where they steal your money and don’t tell you what they’re doing, be my guest.” Rex Sinquefield, co-founder of Dimensional Fund Advisors, went even further, calling hedge funds “mutual funds for rich idiots.” These testimonies and the data that supports them should seal the deal: there is very little reason or necessity for most investors to rely on hedge funds.
Hedge funds are thus an ideal investment vehicle for our current age. They sell “luxury” to people with no concept of value. Effective “gaslit” marketing consistently gets the job done for hedge fund managers. Reality simply doesn’t matter.
Totally Worth It
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This is the best thing I read this week. The loveliest. The scariest. The saddest. The craziest. The coolest. The oddest. The nicest. The best thread. The best news. The best (worst) tantrum. The most surprising. The most absurd. The most horrific. The most incredible. The most impressive. The most remarkable. Paraphrase of the 11th Circuit decision in the Trump records case, overruling the lower court and dunking on the former president. Rats. Red flags. I knew they sounded familiar. Monks & meth. Quite the scam. The ultimate gate-crasher reaches the end of the line. Growing up in the library – literally.
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With this week seeing the 81st anniversary of the attacks on Pearl Harbor, take a few moments to read this 1948 retrospective from the late Maj. Gen. Sherman Miles, the head of the Army’s Military Intelligence Division in 1941.
The TBL Spotify playlist, made up of the songs featured here, now includes more than 240 songs and about 17 hours of great music. The TBL Christmas playlist is here. Whichever one you listen to, I urge you to listen in, sing along, and turn up the volume.
A reader sent this lovely offering this week. Thank you.
Voctave provides this week’s splendid benediction.
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Issue 132 (December 9, 2022)
The advent of an upgraded “best interest” standard of care for brokerage transactions hasn’t changed this reality nearly as much as one might think.
The two sides initially put $640,000 (split evenly) into U.S. Treasury STRIPs that would return $1 million at the end of ten years. However, the financial crisis saw interest rates plunge such that the value of the zero-coupon bonds had already risen to nearly $1 million in 2012. By mutual agreement, the parties sold the STRIPs at that point and bought Buffett’s Berkshire B-shares. The return on BKB blew both the SS&P 500 fund and Protégé’s fund-of-funds out of the water, which meant that Buffett’s chosen charity received $2.27 million in proceeds from the bet.