You Can't Eat Risk-Adjusted Returns

I believe in skill. That is, professional asset managers can add value. Some stock pickers are good at their job. However, the problem is that having no skill usually provides a better return than pure skill. To put it in technical terms, beta has a higher expected return than alpha. To put it less technically, "you can't eat risk-adjusted returns."

The other day, I was having lunch with some old colleagues and we were discussing the difficulty that "market neutral" funds have in gathering assets. On paper, they sound great. The manager shorts stocks they have a negative opinion on in proportion to the risk taken on in stocks they have a positive opinion on. This removes the market volatility from the fund and keeps the pure alpha.

But how much alpha? That's the rub. I would call a stock picker a super genius if they could consistently generate 200 basis points in alpha per year. So, as a customer, you look at the fund offerings out there and can choose between:

• Very safe, short-term fixed income, which now pays over 5%.
• A potentially volatile stock index fund (zero alpha) that has a long-term expected return of, reasonably, 7%.
• A market neutral fund with a generous expected return of, reasonably, 2%, but large potential variation from this number.

Seven, five, or two. See? You can't beat beta.

Maybe you think 200 basis points is too conservative. You can target whatever you want, but any stock manager consistently adding that 200 basis points above the beta return would be in the top decile of managers for any long-term measurement.

What about Peter Lynch, the legendary Fidelity fund manager? He did much better, right? Over his tenure managing the Magellan fund, he returned roughly 30%, double the S&P 500. Kudos to him, but he's the exception that proves the rule.

First off, he earned that return, but you couldn't. Could you have reasonably picked Lynch out of all the mediocrities back when he started? No. Was that track record investable for you? No. The fund was closed and very small for much of its great track record. Did those retail investors who bought the Magellan fund earn anything close to that? No. People, true to form, bought Magellan at the top and sold it at the bottom. The "flow weighted" return for the average Magellan investor was 7%, worse than the index. Kathy Wood at Ark is experiencing the same heartache now. The vast majority of investors in her fund have done terribly.

Finally, consider if there was a pure "alpha version" of Magellan. Since Lynch doubled the index return, a market neutral fund would have simply matched the index return. That would demonstrate incredible skill would we buy it to just match an the returns of an index fund? Admittedly, the answer would be "yes" if we knew the volatility would be much lower, thus making it more likely the flow-weighted return would match the average return.

So, back to market-neutral funds. What are you, the manager, to do when potential customers yawn at the meagre returns on offer? You cheat. You sneak some beta in there. Between 2009 and 2021, the good return of the average hedge fund was attributable to "dumb" beta. We saw the wages of sin in 2022, when hedge funds got slaughtered. Out of something like 4,000 hedge funds in existence, about 80 had returns above zero.

If I'm an institutional fund of funds manager, that puts me in a bind. I have as much chance of picking a winning hedge fund as I do a winning stock. It's very hard and defeats the purpose of hedge funds as a sector allocation to my portfolio. At least a market-neutral mutual fund has lowish fees. Paying "2 and 20" to buy leverage and beta in a hedge fund is not a good deal. Now that short-term rates are so high, leverage is REALLY not a good deal.

So, again, I believe in skill. The best way to access that skill is on top of the beta return the stock market always offers.