Comparing Apples and Oranges
Jesse Redmond
Former Hedge Fund Manager | Dispensary Operator | Cannabis Analyst | Now Building LEEF Brands
A client came to visit and grabbed an apple from the fruit basket and said, "not great." I replied, “not a great year for apples.” He responded, "nothing like those oranges" and pointed to the other side of the basket.
Apples and oranges are not opposites; they are uncorrelated. The apple was from Washington and the orange from Florida. They grow in different seasons, are harvested by different orchards and an expectation of how one will taste should not be based on the other. My client being unsatisfied with his apple because he really enjoyed the orange does not speak to whether or not it is a good apple. He cherry picked - no pun intended - his favorite fruit from the basket and made that his fruit-basket benchmark.
"A comparison of apples and oranges occurs when two items or groups of items are compared that cannot be practically compared. The idiom, comparing apples and oranges, refers to the apparent differences between items which are popularly thought to be incomparable or incommensurable, such as apples and oranges. The idiom may also be used to indicate that a false analogy has been made between two items, such as where an apple is faulted for not being a good orange.”
The press continues to apply the same false analogy to hedge-fund performance. November headlines from major news sources reported, "hedge funds fail to keep pace with stocks." Why is this comparison continuing to be made? From FINalternatives November, 6th, article , “Red October for Hedge Funds:”
"Hedge Fund Research’s HFRX Global Hedge Fund Index fell 1.32% in October, leaving it down 0.15% on the month. By contrast, in spite of suffering serious early-month losses, the Standard & Poor’s 500 Index ended it up, fueled by a late-month market rally.”
I have met with over 1,000 hedge funds and asked: What is the objective of the fund? The answer has never been, "to outperform the S&P 500 in positive months." I'm certain there are hedge funds with this objective, I just have not met one in my decade of due diligence.
Stocks are shaping up to have an above-average year, up 11% through November 6th. Broad hedge-fund benchmarks are not producing, with most up or down a percentage point or two. Hedge funds are not designed to outperform stocks in this environment. Hence, the sophisticated turn to the diversified portfolio explained in great works like Markowitz Diversification Theory:
“Diversification of a portfolio with appropriate regard for the mathematical formulas in Markowitz portfolio theory. That is, Markowitz diversification occurs when one uses mathematical models to find the securities to place in a portfolio such that the portfolio has the highest possible return for its level of risk. One may engage in Markowitz diversification when one wishes to increase or decrease one's portfolio's risk, or when the portfolio was previously not diversified.”
Investors should hope not everything goes up at the same time. This is the same reason the fruit basket was not all apples. Some prefer oranges, and oranges will have years where their harvest is superior to apples. Predicting this in advance is difficult (see orange-juice futures), as is predicting how hedge funds, stocks or any other return stream will perform in the future.
Most investors are programmed, or trained, to use the past as their guide. This leads to performance chasing and perennial underperformance. Ken Fisher, of Fisher Investments, taught me to expect roughly 30% of a portfolio to be down at any time and worry when 90% of a portfolio is up. I learned a tremendous amount from Ken and nothing more valuable than portfolio construction.
Investor's patience is tested when a stock or strategy is experiencing the left tail of its distribution curve while another major asset class, like equities, are harvesting their right tail. Yet, in a diversified portfolio this is inevitable and it should be comforting to see portions of portfolios acting independently. This a a sign of true diversification.
Whether fruit, or investments, winners rotate and the more independent return streams the better. Appreciate stocks strong performance this month and stop comparing them to hedge funds.