Hedge funds - Mistakes, pain, competition, and perhaps not enough risk-taking

“My mom always told me it’s okay to make mistakes, but she never worked at a hedge fund.”

― Turney Duff, The Buy Side: A Wall Street Trader's Tale of Spectacular Excess

Decision-making will be filled with mistakes and failure. It is part of the process when making bets in an uncertain environment. No one is 100% certain and at your best, your track record will match your estimates for success. The objective of good investment decision-making is to get the process right, so failure or lack of success is not from lack of skill or outright ignorance. Nevertheless, even if the odds are in your favor, you will not get every decision right.

The risks are higher for hedge funds because they generally are not managed to a benchmark and should have greater active shares, differences in allocations from some benchmark. The performance costs as a measure of being wrong are higher because they should not be hugging a benchmark.

The stakes are higher for hedge funds because pay is tied to performance incentive fees, and given the competitive nature and size of firms, performance failure will lead quickly to a loss of revenue and assets. The number of hedge fund closings, both large and small, has increased, as their costs of failure have increased.

The industry has become more competitive because investors are less willing to pay for risk factor investing by hedge funds. The demands for skill are greater today than ten years ago. Absolute return is the name of the game. The pain from failure is more real and immediate, yet hedge fund performance, on average, has not been overly rewarding.

Could it be that the average hedge fund is not taking enough risk? Volatility is generally low relative to the market beta but measures of active shares still suggest strong diversification over highly concentrated bets. Oddly, as hedge fund categorization has increased, firm returns may have become more clustered than in the past. Value managers are less likely to switch to growth and value managers may look more like their peers. Hence, there is less unique risk-taking.

Perhaps hedge funds, especially as they have gotten bigger, have diversified away so much risk that after accounting for beta benchmarks and factor risks there is no alpha. Current alpha measures suggest that either there is limited skill or not enough risk-taking. Skill is masked by not taking bets away from core style factors. The complaint today from investors may be that hedge funds are trying to be too safe in order to protect their businesses.