Want to Beat the Masters of the Universe?

It’s official. Macro hedge funds have seen their worst first-half performance since 2013.

These types of funds try to profit from large-scale events or changes within the political and economic arenas. You would think with all the events we’ve had in 2017, macro hedge funds would outperform.

Yet, on average, macro hedge fund managers lost 0.8% for the half-year, after a 1% decline in June. And the broader hedge fund industry isn’t faring much better. As reported by The Australian Financial Review:

The broader hedge fund industry returned 3.7 per cent in the first half after barely making any money last month, and returned about 4.9 per cent annualised over the past five years.

Even investing guru George Soros and his family fund, run by his son Robert, is struggling. Last month, the Soros Fund made fewer macro bets because of ‘lacklustre’ opportunities.

But are fewer opportunities really the reason for poor performance? Unlikely. As mentioned, 2017 has been chockfull of political and economic changes.

A more likely reason why these ‘Masters of the Universe’ haven’t performed is their inability to predict macro outcomes. They’ve just been wrong more times than they’ve been right.

Warren Buffett’s lifelong investment partner Charlie Munger said it best:

A lot of other people are trying to be brilliant and we are just trying to be rational. Trying to be brilliant is very dangerous, particularly when gambling.

Hedge funds are now paying for their ‘brilliance’ with humbling returns. And it is frustrating many of their investors that are now seeking cheaper alternatives to active management. As reported by the AFR:

They [investors] pulled about $US3.8 billion from discretionary macro managers in the first quarter, the fifth straight quarterly outflow, while adding $US4.9 billion into computer-driven macro funds, HFR data show.

But it’s not just computer-driven macro funds. Equity investors are also looking for low-cost higher returns and are piling into cheap index-hugging strategies.

How safe is passive management?

Had you invested in Vanguard’s S&P 500 index fund at the start of the year, you’d be up 9.3%. Had you invested a year ago, your returns would jump to a little over 13.2%. And over five years, your returns would be 80.7%.

Who wouldn’t want to earn 16.14% annually by doing nothing?

Active managers in Australia are facing the same problem. Over the past five years, the All Ordinaries is up 40.3%, or 8.1% annually. It’s not as attractive as the S&P 500. But it’s enough to beat many active funds over the same period.

It’s why droves of investors have piled into exchange traded funds (ETFs) and other index-hugging strategies. Passive management has now turned into an enticing cycle. The more investors that jump into index funds, the higher they climb. The higher they climb, the more attractive passive returns look to other investors.

I urge you not to adopt this return-chasing strategy. Investors who chase returns often do worse than the funds they invest in. The reason why is because they buy near the top (when returns are high) and sell out at lows (when returns are low).

Renowned value fund manager Roger Montgomery elaborates on this point in his white paper, ‘Why investors do worse than the fund they invest in’:

Every investor wants to buy low and sell high, but most investors do exactly the opposite because investment decisions are often driven by emotion. Investors get excited when the market’s rising and everyone else is buying. And of course the flip side, they panic and sell when the market is trending down. This behaviour leads to poor outcomes.

But it’s not just return-chasing which makes passive management, especially in the US, dangerous right now.

Take a look at the graph below. It shows the trends of both the price-to-earnings (P/E) ratio (blue line) and earnings yield (white line) of the S&P 500.

the trends of both the price-to-earnings ratio and earnings yield of the S&P 500.

Source: BigCharts
[Click to enlarge]

Think of the P/E as the price that investors are willing to pay for $1 of earnings. Thus, a P/E of 21.4-times earnings means investors are willing to pay $21.4 for every $1 of market earnings.

The earnings yield is just the inverse of the P/E — earnings divided by price. Think of it as the percentage earned of each dollar invested.

Over the last five years, prices have climbed, but earnings are struggling to keep up. Many investors have already bought into US stocks on anticipated growth. Passive investors who are getting in now are just added to already-high valuations.

What happens if there is a correction around the corner?

The market probably won’t crash, but there is limited room for further growth unless corporate earnings significantly outperform. From here, the S&P 500 has a good chance of producing subpar returns, and you’ll be in the same boat as many hedge funds.

So how can you beat the ‘Masters of the Universe’?

What’s your edge?

Every successful investor has an edge. I would argue your edge is better than most large hedge funds. You might not have their investing experience or extensive resources. But you have something they don’t.

Limited capital.

How is that an advantage? Well, you can invest in many smaller opportunities that hedge funds can’t because of their size. Companies like Big Un Ltd [ASX:BIG] and GetSwift Ltd [ASX:GSW] are far too small for many large funds to jump in and out of. But, had you gotten into these smaller opportunities at the start of the year, you’d be up 454% and 226% respectively.

Even Buffett acknowledges that he’s limited by size. He said in a Businessweek interview in 1999:

‘If I was running $1 million today, or $10 million for that matter, I’d be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow.

‘You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.

I suggest you forget about jumping into a passive index-tracking fund. Instead, think small…and use the advantage you have to outperform the ‘Masters of the Universe’.

Härje Ronngard,
Contributing Editor, Money Morning

PS: Regardless of what you may hear, individual investors will always have some real advantages over large funds. You have more options, and the ability to earn far higher returns, albeit by taking on some greater risks.

Of course, you shouldn’t invest all of your money into smaller stocks. How much you choose is up to you. But, with the right stock selection, you could potentially turn $1,000 into $10,000 in a matter of months. To find out how, click here.

Money Morning is Australia’s most outspoken financial news service. Your Money Morning editorial team are not afraid to tell it like it is. From calling out politicians to taking on the housing industry, our aim is to cut through the hype and BS to help you make sense of the stories that make a difference to your wealth. Whether you agree with us or not, you’ll find our common-sense, thought provoking arguments well worth a read.

Money Morning Australia is published by Fat Tail Investment Research, an independent financial publisher based in Melbourne, Australia. As an Australian financial services license holder we are subject to the regulations and laws of Corporations Act and Financial Services Act.

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