TBP Conf 2013

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    The High Cost of Chasing Performance

    Presentation by Barry Ritholtz

    The Big Picture Conference, October 8, 2013

    McGraw-Hill Auditorium, NYC

    Romancing Alpha,Forsaking Beta

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    1. Herding, Groupthink

    2. Experts: Articulate Incompetents

    3. Optimism Bias

    4. Confirmation Bias

    5. Recency Effect

    6. Emotions impact perception

    7. Anticipation vs. Rewards

    8. Selective Perception & Retention

    9. A Species of Dopamine Addicts

    10. Endowment Effect of Ownership

    11. Monkeys Love a Narrative

    12. Cognitive Errors Impact Processes

    Behavioral Economics Neuro-Finance

    How Does Your Brain Interfere With Your Investing?

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    Thisis

    your

    brainon

    stocks

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    Looking at Alternative Investments

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    1. Hedge Funds manage ~1% of total financial assets

    (Yet capture an disproportionate amount of media mindshare).

    2. Hedge fund 2&20% fees exert enormous drag on returns;

    3. Total Asset Weighted Alpha generated by tiny % of managers

    (Non Gaussian Dispersion = Fat head/Long tail)

    4. Many funds start out creating Alpha but morph into fee capture

    5. Picking new & emerging managers is exceedingly difficult;

    (Your biases make the process even harder)

    Some Surprising Hedge Fund Info

    What Dont You Know About Hedge Fund Investing

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    Global hedge fund industry = $2.13T

    Given what a relatively small asset

    class this is, they receive an excess ofmedia attention.

    Perhaps because so many hedge fund

    managers have become billionaires,

    they have captured the investing

    publics imaginations

    Hedge Funds = 1.1% All Financial Assets

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    How Have Hedge Funds Done?

    2012 = Returns equaled 3.5% versus S&P 500-stock index 16%

    2007-12 = Lost 13.6% vs. S&P 500-stock +8.6%

    2013 = Gained 4.52% YTD vs. S&P 500-stock +14.5% YTD

    Source: WSJ, HFRX

    HFRX Global Hedge Fund Index Performance Data

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    Diminishing Hedge Fund Returns

    Alpha has diminishing returns to scale because many strategies only apply to smaller stocks and/or prices

    move against managers if they try to execute trades that are too large. Source: WSJ

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    1997 = $118 billion

    2012 = $2.04 trillion.

    Hedge Fund Growth

    1. Talent Dilution2. Excess Size3. Correlation / Indexers

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    The Daunting Math of Mutual Fund Manager Selection

    1.Only 20% of active managers (1 in 5) can outperform their benchmarks inany given year;

    2.Within that quintile, less than half (1 in 10) outperform in two out of thenext three years;

    3.Only 3% stayed in the top 20% over five years (1 in 33)4.Once we include costs and fees, less than 1% (1 in 100) manage tooutperform (net).

    5.What are the odds you can pick that 1 in 100 manager?

    Optimism Bias at Work

    Sources: Morningstar, Vanguard

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    56% said they invested in hedge funds for diversification purposes

    Hedge funds correlated with other vehicles, falling in crisis

    Is Your Original Investing theme valid? 81% of investors said Yes (as of 2009)

    Confirmation Bias in Action

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    Managers Capture Investment ProfitsMostly For Themselves

    From 1998-2010 hedge fund managers earned $379 billion in fees. The

    investors in their funds earned only $70 billion in investing gains.

    Managers kept 84% of investment profits, investors netted 16%.

    As many as 1/3 of hedge funds use feeder and/or fund of funds. This brings

    the industry fee total to $440 billion thats 98% of capture.

    Investors are left with $9 billion dollars merely 2%.

    Source: Simon Lack, The Hedge Fund Mirage

    Is This Rational Investing?

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    Who Profits from Hedge Funds?

    Source: Hedge Fund Mirage.via Falkenblog

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    Hedge Fund Manager Profit Capture

    Does not include Survivorship Bias, self reporting. Assume +3%

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    Who Profits from Hedge Funds?

    Source: Hedge Fund Mirage.via Falkenblog

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    2 smart guys leave Goldman Sachs to set up a hedge fund; They raise

    $1 billion dollars:

    Performance:

    Year 1: +15% (Total S&P500+Div=17%)

    Year 2: +10% (S&P500 = 14%)

    Year 3: -5% , (return capital) (S&P500 = 12%)

    Earnings (2 + 20%):

    Year 1: $20m + $30m

    Year 2: $22m + $22m

    Year 3: $24m + $0

    Total Comp = $118m

    Two Smart Guys

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    Comparable Compensation

    Source: Forbes

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    Top Hedge Fund Manager Compensation (Hourly)

    Source: Forbes

    It takes the

    average family

    18.5 years to

    make whatthese hedge

    fund managers

    make in 1 hour

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    1. Herding, Groupthink

    2. Experts: Articulate Incompetents

    3. Optimism Bias

    4. Confirmation Bias

    5. Recency Effect

    6. Emotions impact perception

    7. Anticipation vs. Rewards

    8. Selective Perception & Retention

    9. A Species of Dopamine Addicts

    10. Endowment Effect of Ownership

    11. Monkeys Love a Narrative

    12. Cognitive Errors Impact Processes

    Behavioral Economics Neuro-Finance

    How Does Your Brain Interfere With Your Investing?

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    Understand What You Can and Cannot Do Well As Managers

    -How overweight in alt (PE/HF/VC) investments are you?

    -Focus on Asset Allocation (15 distinct classes)-Use Core & Satellite Approach to Reduce Temptations

    -Take Advantage of Mean Reversion via class rebalancing-Lower your expectations until the next 1982 comes along

    -Think longer term

    -Get Unsexy!

    What Should Investors Do ?

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    We have met the

    enemy, and he is us.

    -Walt Kelly, Pogo, 1971

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    Supplemental

    Materials

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    Manager Selection isMuch Harder Than People Believe

    -John Paulson launched his hedge fund in 1994

    -Hires Paulo Pellgrini in 2004-Raised $147 million in 2006 for Subprime Bet

    -Greatest Trade Ever in 2006-07-Assets under management had swelled to $36 billion.

    -Subsequent losses were 52% in one fund, 35% in another.

    Paulson Hedge Fund

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    Manager Selection isMuch Harder Than People Believe

    Paulson gave Pellegrini a $175 million bonus . . .

    Response: F#$% you, I quit

    Formed PSQR in 2008

    Returns:

    2008 = 40%

    2009 = 61.6%

    2010 = -11%

    August 2010, Pellegrini returned all outside investor capital

    Pellegrini PSQR Hedge Fund

    Sources: Greg Zuckerman, The Greatest Trade, WSJ

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    Hedge Fund Attrition WhenafundleavestheLipperTASSdatabaseorstopsrepor7ng,thedatabaselistsone

    ofthefollowingasthepossiblereason: Fundclosedtonewinvestment. Funddormant. Fundhasmergedintoanotheren7ty. Fundliquidated. Fundnolongerrepor7ng. Programclosed. Unabletocontactfund. Unknown.

    92%offundsthatleavethedatabaseareassignedtojustthreeofthe8reasons:fundliquidated(36%),fundnolongerrepor7ng(38%),andunabletocontactfund(18%)

    Ifafundleavesthedatabasebecauseitliquidated,itissafetoassumethatthedecisionwasbasedlargelyonpoorperformance

    Theari7onforfundsthatreportedreturnsforthemonthofDecember2006(whichcoversthe24monthsthrough2008)isalarminglyhigh-29%to63%ofthefundsseemtohavedisappeared

    Basedontheseari7onrates,onecanexpectanywherefrom20%to60%ofthefundsrepor7ngatanygiven7menottolastthroughthenext24months

    Suchhighari7onratescanhaveseriousconsequencesforlong-terminvestors Vanguardalsoreportstheaverageannualizedexcessreturnsofthefundsthat

    disappear.Theexcessreturniscalculatedwithrespecttothepeersinthehedgefundcategories

    Source:hps://www.vanguardinvestments.se/content/documents/Ar7cles/Insights/alt-vs-indexing.pdf

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    Underperformance:

    Themajorityoffundssixty-twooutof100failedtoexceedreturnsavailablefromthepublicmarkets,a\erfeesandcarrywerepaid.

    ThereisnotconsistentevidenceofaJ-curveinventureinves7ngsince199;thetypicalKauffmanFounda7onventurefundreportedpeakinternalrateofreturn(IRRs)andinvestmentmul7ples

    earlyinthefundslife. Thecumula7veeffectoffees,carry,andtheunevennatureofventureinves7ngul7matelyle\us

    withsixty-ninefunds(8percent)thatdidnotachievereturnssufficienttorewardusforpa7ent,expensive,long-terminves7ng. (hp://www.kauffman.org/uploadedFiles/vc-enemy-is-us-report.pdf)

    AreportbytheNa7onalVentureCapitalAssocia7on(NVCA)statesthat,Itisinteres7ngtonotethat2012isthefirstpost-bubbleyearinwhichventurefundscollec7velydistributedmorecashtolimitedpartnersthantheybroughtin.(hp://www.prweb.com/releases/2013/5/prweb1000.htm)

    (http://smullaney.com/wp-content/uploads/2010/12/VC-Performance1.jpg)

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    Outperformance:

    Bain & Co. in their 2013 GlobalPrivate Equity Report claim that,despite falling returns (above)and increased volatility (top

    right), buyout funds still

    outperformed the S&P 500(right).

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    Source: Ritholtz.com

    Emotions & the Sentiment Cycle

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    Barry L. Ritholtz

    Ritholtz Wealth Management90 Park Avenue, 18th Floor

    New York, NY 10016

    212-455-9122

    [email protected]

    for more information, please contact