Hedge funds amid low returns

While there is a great deal of debate and discussion on the short-run outlook for financial markets, most investors are on the same side when it comes to thinking about financial market returns over the coming decade.

Looked at through the construct of financial market history and simple mathematics, it becomes quite clear that global financial markets and especially the US are in for a sustained period of mediocre financial returns.

While the last 20 years were spectacular for financial markets, in the coming decade we will be lucky if the US equity markets deliver us a nominal return of even 6.5–7 per cent per annum (compared to a 1950–95 average of 13.2 per cent).

Why has the notion of low equity market returns for the US over the coming decade become such accepted wisdom? What is the rationale?

First the history. The 18 years between 1982 and 2000 witnessed the greatest ever combined bull market in stocks and bonds. Between the third quarter of 1982 and the third quarter of 2000, the S&P 500 delivered a real compound return of 15 per cent per annum, while long-dated treasuries returned almost 9 per cent real per annum.

Compare this to 5.3 per cent real and less than 1 per cent for the same asset classes over the previous 100 years.

The first part of the case for low prospective returns is a simple regression to the mean type of argument. The last 20 years' returns are way above the long-term trend and we will now witness an extended period of lower than trend returns to compensate.

The second argument is based on a decomposition of prospective equity market returns. Equity market returns can be broken down into three simple components: earnings growth, P/E multiple expansion/contraction, and dividend yields. Taking each of these components individually, the results make for grim reading.

For earnings growth, if history is any guide, the best case outcome is earnings per share growing in line with nominal GDP. If you look at data going back to 1960, you will find that while total corporate profits in the US grew in line with nominal GDP, S&P 500 EPS under-performed (due to dilution).

Thus, to assume that S&P 500 EPS actually grows in line with nominal GDP at 5 per cent per annum over the coming decade is beginning quite generous.

Most investors will not quibble with a 5 per cent nominal GDP number (3 per cent real, 2 per cent inflation) for the coming decade, given the GDP growth of 5.2 per cent over the last 10 years and the current inflation and potential growth expectations.

If the share of corporate sector profits/GDP were to rise, it is the only way that S&P 500 EPS can outgrow 5 per cent. This looks unlikely, given that the ratio of corporate net profit/GDP is already at an all-time high in the US, with effective tax rates at an all-time low of 22 per cent.

The share of corporate profits to GDP is more likely to come down from these levels than rise, again highlighting that the EPS growth of 5 per cent per annum over the coming decade is a generous number.

As for the P/E multiple, currently the S&P 500 is trading at over 18 times trailing operating earnings. While lower than the 30 times reached in 2000 at the height of the bubble, 18 is still near an all-time high (ex 1998–2000) and much above the historical mean of 14–15. To expect P/E multiple expansion from these levels to boost returns over the coming decade is thus highly unlikely.

As for dividend yields, at 1.7 per cent the market yield is much below the 4.2 per cent average (1950-95) and only serves to further highlight the poor return prospects over the coming decade.

Thus, you have it. Assuming an EPS growth of 5 per cent per annum, no P/E contraction, and re-invested dividends of 1.7 per cent -- all optimistic assumptions I would argue --nominal returns for the S&P 500 over the coming decade will be 6.7 per cent per annum (source: BCA).

Assuming a 2 per cent inflation rate, real returns drop to only 4.6 per cent. The average US market returns over the 1950-1995 period were 13.2 per cent nominal and 8.6 per cent real, much above what we are expecting for the coming decade. This 6.7 per cent annual return number would be even lower if P/E multiples were to actually contract over the coming decade as history would suggest.

If the above numbers are even remotely correct, then we have an interesting dilemma for the hedge fund community. There are now over 8,000 hedge funds in operation, managing over $1 trillion, and all of them targeting double-digit returns.

While the above analysis is US equity-specific, the bulk of the hedges are US-centric and focused on equities. So how will they generate double-digit returns when the markets are only returning 6-7 per cent at best?

One answer could be that hedge funds have great investment discipline, can go short, and can attract the best talent. Armed with the best minds in the business, anything is possible. While some hedge funds are outstanding and have great records, this is not necessarily true of the entire class.

The majority of hedge funds have actually under-performed the S&P 500 so far this year. Surprisingly, despite all the hype about hedge fund performance, the CSFB Tremont Hedge Fund Index has barely outperformed the S&P 500 over the last decade.

To chase performance, you could see hedge funds load up on leverage and go further out on the risk curve. While this strategy may deliver strong performance for a period, it is unlikely to lead to sustained performance. Leverage, as any investor ultimately discovers, is a two-edged sword.

Another option could be that many of the bigger funds move more money overseas. A combination of a weak dollar, lower valuations leading to higher prospective returns, and more inefficient markets may be enough to enable the best funds to hit their double-digit returns target.

It is probably no coincidence that many of the biggest and best hedge funds have begun to look at Asia far more seriously over the past 12 months. This trend will continue as the smart money realises that to deliver a double-digit return consistently from US equities is challenging.

Whether they deliver their returns or not, the hedge funds will make sure that the markets stay volatile and trigger-happy. Imagine billions of dollars chasing every new idea and concept, with no benchmark constraints and minimum-holding horizon.

Add in huge leverage and the environment is ripe for boom/bust cycles in specific ideas and concepts. The markets will tend to discount events rapidly, overestimate growth, and be very quickly disappointed. The reaction time investors have to process and comprehend new information will undoubtedly reduce.

While there is a hedge fund boom currently under way, and most managers are sure they can deliver double-digit returns, the simple arithmetic of markets seems to dictate that most of them are doomed to fail.

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