Ted,

Thanks for putting together such a thoughtful, carefully documented analysis. It’s really excellent. With great respect, though, I think the story for hedge fund managers is much worse than you acknowledge.

The argument in favor of hedge funds basically comes down to investing where “the best and brightest spend their time” (to use your own phrase). And the problem with The Bet—and the 7-year period you analyze—it that it made you (plural, meaning hedge fund managers generally) look like anything but “the best and brightest.” You thought the S&P 500 was overvalued in 2007; it turned out it was not. You were caught off-guard when global equity markets underperformed the S&P 500. You were caught off-guard when the Fed pursued its Zero Interest Rate Policy. You were caught off-guard when the cost to borrow stock for shorting “rose significantly.” As a result of your failure to anticipate these shifts and events, the random actions of comparatively stupid people ended up soundly defeating the extraordinarily thoughtful (and costly!) actions of “the best and the brightest.”

As for the future, you point out big, big two secular problems. First, regarding short-selling, “the growth of the hedge fund industry has created more competition for desirable stock to short,” making short positions more expensive. More importantly—and this is likely true of all active investment, not just short-selling—“when markets were opaque, middlemen and borrowers had asymmetric information about prices and took advantage of less-informed” investors (not just lenders), but the opacity that managers depended upon has shriveled.

Neither of those is a cyclical phenomenon, so both suggest that the risk-adjusted net total returns of hedge funds are likely to be worse in the future (relative to passive portfolios) than they have been in the past. Unfortunately, the days of outperformance by hedge fund managers already seem to have been in the past even before you took on The Bet seven years ago. In fact, 2007 was the same year that Naik, Ramadorai & Stromqvist (http://intranet.sbs.ox.ac.uk/tarun_ramadorai/TarunPapers/CapacityConstr…) reported that hedge fund “alpha generation occurred primarily during the peak of the bull market period between October 1998 and March 2000” but that “alpha in the hedge fund industry has severely declined in the most recent sub-period in the data, from April 2000 to December 2004. They concluded that “capacity constraints (too much capital) do exist at the level of hedge fund strategies, and are likely to be a concern for investors going forward.” That sounds like a much better prediction, circa 2007, than your own.

The biggest problem for the hedge fund industry, in my mind, is simply that it represents an extremely high-cost way of achieving something that has always been easy to do at extremely low cost. When hedge funds are at their best, what do they accomplish? The answer is this: low beta relative to the equities market, and low returns that are nevertheless good on a risk-adjusted basis. But that is what bonds have always provided. The CEM Benchmarking study (sponsored by my employer, NAREIT, and available at https://www.reit.com/investing/industry-data-research/research/cem-benc…) bears this out using data on actual investment results for more than 300 U.S. pension plans over the period 1998-2011 (much longer than The Bet): hedge funds were the second-worst performing asset class at 6.02% per year even before investment costs, and their extraordinarily high investment costs (125.1 bps/yr) made them the absolute WORST asset class with net returns of just 4.77% per year—lower than all four fixed income categories, which had investment costs ranging from just 17.3 to 42.0 bps/yr.

Also on the (lack of) diversification benefits of hedge funds, check out the new article “Fees Eat Diversification’s Lunch” by Jennings & Payne (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2543031), which finds that “investment fees consume 91% of the structural benefits of diversifying into hedge funds” (for a typical small institutional investor) and points out that “investment management fees are a certain deadweight loss while the riskiness of the diversification benefit remains, even when the allocation alpha is large.” The authors conclude that “investors might be wiser to increase their equity allocation than to seek additional returns from diversification to expensive alternative assets.”

Finally, a significant long-term problem with the hedge fund industry is overconfidence among its managers. (I’m talking about overconfidence broadly as a set of cognitive biases that includes, for example, illusory superiority.) Among the causes of overconfidence is “retroactive pessimism,” which makes it easier to explain a failure even within the context of excessive self-regard. Tykocinski, Pick & Kedmi defined it this way: “In an attempt to regulate disappointments people may sometimes change their perceptions of the events leading to an undesirable outcome so that in retrospect this outcome seems almost inevitable.” That sounds a lot like your statement that “the residual performance after adjusting for the impact of this investment environment manifests a return stream that could have been beneficial to a diversified portfolio of risk assets under different circumstances.”

Again, thanks for doing this excellent analysis.