High-tech Investing

 Dr Larry Haverkamp
The Sunday Times
30 October 2016

At the new technologies in the market can make your head spin. But how about investing? Does it have new innovations to lower costs, raise returns and reduce risk?

The answers are 'eyes, yes and yes'. We have had four investing innovations: ETFs, hedge funds, private equity and sovereign wealth funds.

ETFs are nearly an passively managed, which means they are index funds that simply duplicate a market index. like the S&P 500 in the United States or the Straits Times Index in Singapore.

The other three funds are actively managed, which means they try to do better than a market index by superior stock picking and market timing.

CAN IT BE DONE?
Of course, the billion-dollar question is. "Can it be done? Can smart managers out-perform the marker?" The answer, so far, has been "no," but hope springs eternal.

This optimism explains why we have actively managed funds and
the most well-known are hedge funds with US$3 trillion (S$4.18 trillion) of assets under management.

It matches the US$3 trillion in sovereign wealth funds, US$3 trillion in ETFs and US$1 trillion in private equity funds. Alt have sprung up from almost nothing 30 years ago.

Perhaps the biggest question is whether active management really works. Research indicates that it doesn't, because actively managed funds, on average, have failed to beat their benchmarks.

It means that passively managed funds, like ETFs, perform as well as actively managed ones. And they do it at a much lower cost since ETFs don't need to hire high-priced experts to pick the best shares. They simply duplicate an index by buying all the shares in the index.

The lowest-cost ETF charges an expense ratio of 0.04 per cent per year, which is only 40 cents for every S1,000 invested. It is not much, especially since ETFs do not charge a performance fee.

It compares to hedge funds which charge "2+20" which means a 2 per cent annual expense ratio and a 20 per cent performance fee above a minimum return. This cost has come down slightly in an effort to win back business lost because of low returns.

DO THEY OUT-PERFORM?
The big question is whether it is worth the money? Have hedge funds really outperformed their benchmarks?

Incredibly, no one can say for sure, as nearly all hedge funds declare themselves unique and so they don't have a benchmark. They judge themselves successful if they simply make a profit and not a loss.

These are called 'absolute return' funds and besides having no benchmark, many also use high leverage. Then, an investment might earn only 3 per cent but with three times leverage, the return rises to 9 per cent. Of course, leverage can also magnify losses.

Three times leverage may look high, but it isn't much when you consider that others have used extreme leverage, like investment banks that carried 30 times leverage prior to the 2008 financial crisis.

The stories hedge funds tell may be even more important than the numbers, especially if there are no benchmarks. Take high-yield bonds, commonly called junk bonds. By analysing the bond contracts one by one, it should be possible to pick out the best to produce high returns.

Well, that is the sales pitch. The problem is there is no obvious benchmark to compare to those leveraged returns.

Another example is emerging markets. Supposedly, experienced analysts can pick the best stocks in developing economies - like Africa - while developed stock markets have a longer history and are more efficient, making it more difficult to find a bargain. Again, the story sounds reasonable, but there is no obvious benchmark to use for comparison.

One more: Guessing the target company in a future take-over would be a sure money-maker. But can it be done and do hedge funds that try succeed? Again, the story is compelling but we don't have enough data from hedge funds to know.

The stories may have succeeded more than data in boosting hedge fund capital to an incredible U5S3 trillion.

Recently, however, investors have grown restless and some have given their required three- to six-months advanced notice to withdraw money, causing hedge fund assets to decline slightly while ETFs have continued to grow.

PERFORMANCE PARADOX
Hedge funds have an impressive record of returning 10 per cent in the last 25 years compared to 9 per cent for the S&P 500. And they did it with less than half the volatility of the S&P 500. That means the returns were high and the risks low, which is the standard measure of a fund's success.

But, as you may suspect, there is a catch. It seems that hedge funds earned spectacular returns of 18 per cent per year in the first decade, from 1990 to 2000.

Then, in the most recent decade from 2005 to 2015, hedge funds returned only 3.5 per cent per year. It is a low return that is hard to justify.

The billion-dollar question is "What happened? Why have hedge fund returns dropped so drastically?' And 'Do they have a future?'

It isn't certain but maybe - just maybe - all markets have become more efficient, which makes it harder for hedge funds to out-perform any index bonds, emerging markets or takeover targets.

That is one explanation. Another is that it is only a temporary market blip and hedge funds will make a comeback.