Why the Wall Street Dealers Can’t Deliver What You Can

As an economist, John Maynard Keynes’ intellectual rigor left much to be desired.  As an investor, Keynes was frequently spot on.  He understood Wall Street and approached it with a keen, skeptical eye – once observing, “The dealers on Wall Street could make huge fortunes if only they had no inside information.”
I can’t say for sure how much inside information the Wall Street dealers possess; I imagine it’s more than you and I.  But as Keynes observed 80 years ago, it seems to be doing them little good.
Hedge funds – run by the ultimate Wall Street dealers – were sorry losers in 2013. Through November 2013, the Bloomberg Global Aggregate Hedge Fund Index returned 7.1%.  That was roughly 22 percentage points less than the S&P 500 Index with reinvested dividends.
2013 was hardly a one-off aberration.  Hedge funds have underperformed the S&P 500 by 97 percentage points since the end of 2008.
Hedge funds might be run by dealers privy to information inaccessible to you or me, but they live in a cloistered universe. What one hedge fund manager knows, another is likely to know, or soon will.
I say that because an investment strategy that proves initially successful draws immediate and fierce competition. High returns are a magnet for competition, and competition always reduces returns.
Worse, hedge funds are plagued by “immediacy” –  the imperative to deliver immediate return.  Once the lock-up period – which can last 30 days to three years –  is over, investors are free to leave. They frequently do if the fund fails to generate superior return every 90 days.
When a cluster of non-superior returns are strung together (an eventuality), failure frequently follows.
In an academic paper titled “Why Do Hedge Funds Stop Reporting Their Performance,”  academic Burton Malkiel and his colleagues report failure rates for hedge funds are extremely high (precise numbers are unavailable).  Furthermore, Malkiel found that failure risk cannot be mitigated by restricting purchases to funds with established records of past success (see above on competition).
From my experience and observations, compensation structure contributes to the high failure rate.
You might be familiar with the term “two-twenty,” shorthand for 2% of money under management and 20% of the gains. Investors rightfully demand a lot when management takes a lot. The pressure to continually generate high return – quarter after quarter – can degenerate to excessive, if not desperate, trading schemes.
Desperation manifests in style drift.  For example, a hedge is marketed on a long/short equity strategy – buying some stocks and shorting others.  Now this same fund extends into ancillary activities, such as derivatives trading. This is a sign the fund is following the latest fad, and fads usually end badly.
Mutual funds are similarly hindered by fees, excessive trading, style drift, and immediacy.  I’ll occasionally thumb through Standard & Poor’s Indices Versus Active Funds (SPIVA) Scorecard. Without fail, it will reveal how poorly mutual funds perform. The latest edition shows that 72.1% of all domestic equity funds have failed to outperform their respective benchmarks.
You and I are better positioned for success compared to the Wall Street dealers than you might realize.
For one, intelligent long-term investing decisions can be made using public information. Keynes alluded to this in his comment on Wall Street and insider information.
You and I can avoid excessive fees diminishing our returns:  A one-way trade can be executed for $10 or less at most online brokerages.
You and I are free to trade as frequently or infrequently (preferably infrequently) as we like.  There is no institutional imperative to beat a benchmark every 90 days, or even every year. The freedom to stick to a proven plan is invaluable.
I can speak from experience. I’ve owned stocks that have literally gone nowhere for years, but then suddenly spiked higher.  When price appreciation and dividends were tallied, the annual average return frequently exceeded the market return over the same period. Patience truly is a virtue.
To many readers what I’ve said sounds like preaching to the choir. Fair enough. But sometimes the choir needs to be preached to so that it appreciates its precious advantage.

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