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ISMS 40: Larry Swedroe – Market vs. Hedge Fund Managers’ Efficiency

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Quick take

In this episode of Investment Strategy Made Simple (ISMS), Andrew gets into part two of his discussion with Larry Swedroe: Ignorance is Bliss. Today, they discuss two chapters of Larry’s book Investment Mistakes Even Smart Investors Make and How to Avoid Them. In this series, they discuss mistake 30: Do You Fail to Understand the Tyranny of the Efficiency of the Market? And mistake 31: Do You Believe Hedge Fund Managers Deliver Superior Performance?

LEARNING: Discovering anomalies or mistakes reinforces and makes the market more efficient. Hedge fund managers demonstrate no greater ability to deliver above-market returns than do active mutual fund managers.

 

“Unfortunately, the evidence is hedge fund managers demonstrate no greater ability to deliver above-market returns than do active mutual fund managers.”

Larry Swedroe

 

In this episode of Investment Strategy Made Simple (ISMS), Andrew gets into part two of his discussion with Larry Swedroe: Ignorance is Bliss. Larry is the head of financial and economic research at Buckingham Wealth Partners. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.

Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss two chapters of Larry’s book Investment Mistakes Even Smart Investors Make and How to Avoid Them. In this series, they discuss mistake number 30: Do You Fail to Understand the Tyranny of the Efficiency of the Market? And mistake 31: Do You Believe Hedge Fund Managers Deliver Superior Performance?

Did you miss out on previous mistakes? Check them out:

Mistake number 30: Do You Fail to Understand the Tyranny of the Efficiency of the Market?

According to Larry, the Efficient Market Hypothesis (EMH) is the most powerful hypothesis or theory because the very act of discovering anomalies or mistakes reinforces and makes the market more efficient. When somebody discovers an anomaly, it gets published, people read about it, exploit it, and the anomaly typically will disappear or shrink dramatically.

Pricing anomalies present a problem for those who believe in EMH. However, the real question for investors is not whether the market persistently makes pricing errors. Instead, the real question is: are the anomalies exploitable after considering real-world costs?

Mistake number 31: Do You Believe Hedge Fund Managers Deliver Superior Performance?

Hedge funds, a small and specialized niche within the investment fund arena, attract lots of attention. Hedge fund managers seek to outperform market indices such as the S&P 500 Index by exploiting what they perceive to be market mispricings. Studying their performance would seem to be one way of testing the EMH and the ability of active managers to outperform their respective benchmarks.

Over the last 20 years, hedge fund managers have underperformed one-month Treasury bills by something like 1.4% for T-bills to 1.2% for hedge funds. A study by AQR Capital Management covered the five-year period ending January 31, 2001. The study found the average hedge fund had returned 14.7% per year, lagging the S&P 500 Index by almost 4 ppts per year.

The 2006 study, “The A, B, Cs of Hedge Funds: Alphas, Betas, and Costs,” covered the period from January 1995 through March 2006 and found the average hedge fund had returned 8.98% per year, lagging the S&P 500 Index by 2.6 ppts per year.

Hedge fund investing appeals to investors because of the exclusive nature of the club. It also offers the potential of great rewards. Unfortunately, the evidence is hedge fund managers demonstrate no greater ability to deliver above-market returns than do active mutual fund managers. At the same time, investors in hedge funds were earning below-market returns. They were (in many cases) assuming far more risk — although they were probably unaware they were doing so.

In addition to these risks, hedge funds also tend to be highly tax inefficient and show no persistent performance beyond the randomly expected, meaning there is no way to identify the few winners ahead of time.

About Larry Swedroe

Larry Swedroe was head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.

Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.

Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.

Larry is a prolific writer, regularly contributing to multiple outlets, including AlphaArchitect, Advisor Perspectives, and Wealth Management.