Many individuals hate investing. It is complicated and confusing. Even simple math can put otherwise intelligent, well-rounded people into cold sweats. Some independent investors are comfortable running their own books, but most folks prefer someone to tell them what to do or, better yet, take care of the job for them.
There is a whole universe of different kinds of financial advisors, consultants, planners and managers. Hedge funds loom large in this universe. They are supposed to be the ultimate “smart money” managers. Their whole raison d'être is to beat the market in order to deliver genuine alpha to their clients. Risk-averse allocators who are happy to take the market return can go to Vanguard. Those who go with hedge funds expect to beat the market.
Yet, in 2018, hedge funds performed terribly. Unsurprisingly, that has angered a lot of investors -- and sparked renewed media and analyst interest in the value of these investment vehicles.
In this research note, we discuss the performance of the hedge fund industry in 2018; we will attempt to address what -- and why -- it was such a disastrous year for the smart money gurus.
Humbling of the gurus
Hedge funds’ services certainly do not come cheap, despite some efforts by larger allocators to force fees down to more reasonable levels. So, if you are going to hand your investment capital over to someone who expects to take 2% of your principal every year as a fee before then carving off 20% of profits earned, they better be good at what they do.
Hedge fund performance last year did little to justify those fees, or to placate increasingly anxious (and unforgiving) allocators. In fact, 2018 saw hedge funds deliver their worst annual return since 2011. As a group, they certainly failed to earn their fees (not that it stopped them from taking them, of course).
Many of the greatest living investment managers were among those who came out of 2018 battered and bruised, with their time-tested strategies and proven stock-picking prowess failing to evade disaster. Some of the investment gurus loom large in the GuruFocus community. Among these beaten-down gurus are David Einhorn (Trades, Portfolio), Daniel Loeb (Trades, Portfolio) and Bill Ackman (Trades, Portfolio).
Let’s take a brief look at each of these gurus’ performance in 2018.
David Einhorn (Trades, Portfolio): Worst year ever
Last year, David Einhorn (Trades, Portfolio)’s Greenlight Capital posted its worst result in its 22-year history, as GuruFocus’ Sydnee Gatewood discussed in a recent article. Finishing out the year with a brutal 9% drop in December, Einhorn’s fund was down a whopping 34% for the year, far worse than the broader stock market.
Einhorn’s three largest positions all dropped badly in 2018. Brighthouse Financial (BHF) declined 48%, Green Brick Partners (GRBK) 36% and General Motors (GM) 18% over the course of the year.
A short against Tesla (TSLA, Financial) added further to Greenlight’s woes, as the electric-carmaker managed to retain its sheen despite facing a raft of problems ramping the production of its Model 3 sedan.
Daniel Loeb (Trades, Portfolio): Battered by a bad December
Daniel Loeb (Trades, Portfolio)’s Third Point Offshore Investors Ltd. fund entered December already in the red, but things really went off the rails as the year came to a close. As Holly LaFon has already reported in a recent article, Daniel Loeb (Trades, Portfolio)’s hedge fund lost a whopping 6.2% in the final month of the year, bringing the total loss for 2018 to 11.1%.
Loeb cited poor performance of his industrials, consumer products and financial stocks as all contributing to the end-of-year rout, with a few short positions actually serving to mitigate some of the damage. Loeb suffered marginally from exposure to biotech, a sector that did badly across the board in 2018. One such position, Kadmon Holdings (KDMN), proved his worst performer, with the small biopharma company costing Loeb 72% of his investment.
Since its inception, Third Point has delivered an annualized return about double that of the S&P 500, so Loeb’s longtime clients have not suffered overmuch from the poor showing last year. An occasional down year will not scare off an allocator who has been enjoying long-term alpha, but more market turbulence could make things tougher for Loeb. One of Loeb’s best performers was Netflix (NFLX), despite the broad year-end tech stock correction weighing heavily on the streaming service company.
Bill Ackman (Trades, Portfolio): Dipping into the red thanks to fees
Bill Ackman (Trades, Portfolio)’s Pershing Square Holdings had a better year than either Greenlight or Loeb’s Third Point, though that is hardly saying much, as LaFon discussed in her article of last week. Before fees, Ackman was actually in the black -- if only by 0.7%. But his clients did not get to share in even those meager rewards; fees ate up all the gains and even tipped clients narrowly into the red.
This is now the fourth year in a row in which Ackman’s investors have taken a beating. On the bright side, his losses have been narrowing each year. Over the past four years (including 2018), Pershing Square lost 16.2%, 9.6%, 1.6% and 0.7%. If the pattern holds (an obviously dubious assumption), investors might expect a brighter 2019. Many are not convinced, however, that the 10-year hot streak that first made Ackman famous is coming back soon. At the end of 2014, Ackman was managing $18.3 billion. At the end of 2018, he was down to $6.8 billion. Given his track record over the past four years, it is a testament to his reputation that so many allocators are still keeping the faith.
So much for hedging
As has so often been the case, active fund managers have underperformed the broader stock market (net of fees) yet again. But 2018 was especially egregious. That is because, for the last several years, top hedge fund managers have fought to justify their existence on the grounds that their active strategies and sophisticated hedging techniques, while perhaps underperforming a multi-year bull run across the market, would really shine in a down year. After all, that is where the “hedge” in hedge fund comes from. Yet, despite the volatility and crashing fourth quarter, hedge funds still did poorly.
One problem is that modern hedge funds have kept the name, yet diverged massively from the strategies that originally defined the class. If hedge funds cannot beat the market either in up markets or down markets, their relevance starts to look questionable.
In a recent article for GuruFocus, Rupert Hargreaves asked what went wrong for many of the hedge funds that turned out awful performances in 2018. One thing he found was overconcentration on the part of some of the worst performers:
“Concentration isn't always bad but it does come with extreme volatility, and most investors cannot deal with this level of volatility. Something to consider for 2019.”
This is probably sage advice, given that the volatility and uncertainty that sent markets off the rails in the fourth quarter appear here to stay.
Verdict
Investors thinking about allocating to hedge funds (or trying to emulate a hedge fund strategy) should be especially wary, since hedge fund performance in 2018 was actually better than it might otherwise have been. While diversified strategies, such as macro funds, did fairly well for the whole year, they were down substantially during the final quarter. Indeed, all major hedge fund categories were down during the fourth quarter.
It is impossible to know how 2019 will play out for hedge funds, but if the chaos of the fourth quarter of 2018 is any lesson, they are in for a wild ride. Investors should be extremely careful before entrusting their funds to active managers, especially those with questionable skill in navigating heightened volatility.
There are easier ways to underperform the market, and they do not usually demand hefty fees for the privilege.
Disclosure: Short Tesla via long dated put options.
