A typical core and satellite portfolio approach involves investing in a “core” passively managed portfolio, and a “satellite” actively managed portfolio. The “core” is typically an index-tracking portfolio whose returns are driven by exposure to specific risk factors. Unfortunately, broad hedge fund index clones, that are currently being sold as “core” risk exposures are not exactly that. As I argued in my previous post, these clones attempt to replicate a mix of “cloneable” and “non-cloneable” funds, i.e. they are in fact “core” and “satellite” portfolios rolled into one product, with no transparency on the exact mix.
Cloning hedge fund indexes with liquid portfolios is hot these days. Major players, including Goldman Sachs, Morgan Stanley, Barclays, Societe Generale, and BNP Paribas, now offer hedge fund index clones. But guess what? These clones underperform the hedge fund indexes they were designed to replicate! The clone sponsors readily admit that, pointing to many technical reasons as to why that is the case (and a recent study by Ben Dor, Jagannathan, Meier, and Xu does a great job in explaining these). However, the most fundamental question is not usually mentioned at all – I mean, why is cloning expected to work in the first place?
Hedge funds charge hefty fees. Because they are that good (or so they claim)! They seem to provide good returns that have little in common with the overall stock market return (S&P 500), or U.S. bond market returns. But what is the source of their returns? Is it a stream of new and ever ingenious investment ideas generated by the hard work of a hedge fund manager, or could it be some “secret formula”, discovered long ago, and run by a computer, while the hedge fund manager is now busy golfing and fishing? An example of such a strategy would be just writing out-of-the-money put options on the S&P 500 index.
I, personally, have nothing against paying high fees for truly new investment ideas, generating high returns. For example, SAC’s 50% performance fee sounds like a fair deal for “sure-thing” returns generated by insider tips (oh, if only that strategy was legal)… On the other hand, I do have a problem paying a 20% performance fee as a “royalty” to a computer running a formula discovered a long time ago. However, if nobody else on the market offers returns based on the same (or similar) formula, then I am stuck with that hedge fund. And that is exactly what the situation was until recently.
Innovation is the ultimate driver of economic growth. Innovations big and small are essential for us to be better off tomorrow than we are today. However, it is also critical to sort out good innovations from wasteful ones. Good innovations then have to be adequately financed and nurtured in order to develop to their full potential. Financing potential breakthroughs in technologies “like we’ve never seen before” requires expertise, vision, and guts, as most radically new ideas may initially sound like “crazy talk”.
It is no secret that Main Street suspects that Wall Street high finance provides little meaningful contribution to society. Recent history suggests to a non-financial person that finance may in fact be taking rather than contributing. This opinion is expressed everywhere from Oliver Stone’s original “Wall Street” to the more recent Greg Smith’s “Why I am Leaving Goldman Sachs”. Even people in the finance industry have this nagging feeling about the purpose of life, as Matt Levine pointed out in his comment on Greg Smith’s article:
Smith is hardly the first banker to worry about whether his work makes the world a better place. Working at an investment bank involves trading off those negatives – stress, hours and a nagging sense of unfulfilled purpose – against the positive aspects of the job, which can be loosely summarized as “huge paychecks.”
The most effective investments … are investments in politics.
– Boris Berezovsky
Am I seriously quoting the late Russian oligarch about investments in politics? After all, Berezovky brazenly manipulated political outcomes in Russia for personal gain. Am I implying that investors do the same? Not exactly… While it is certainly not possible for a typical investor to manipulate the political landscape on such a grand scale, it is possible to achieve superior returns by taking the time to understand politics in order to anticipate developments that affect all financial markets.
Once you start thinking about economic growth, it’s hard to think about anything else.
– Robert E. Lucas
Q: What is the difference between maintaining sound fiscal policy and running a pyramid scheme with respect to government debt?
A: It all depends on the economy’s predicted growth rate.
What is economic growth, where does it come from, and how do we measure it? These are simple questions, but it is fundamentally important to get them right in order to understand what is ahead for the U.S. economy, and how its growth relates to government fiscal policy. Here I would like to take a look at how we measure economic growth, and argue that sometimes true economic growth may not be what it seems, at least in the short term.