Sebastian Mallaby: belief

Transcript context

…Let’s say there are some hedge funds that are quite special, but it seems a lot, the large numbers are not. Yet they’re still doing some version of 2 and 20 fee structure. How is that sustainable if a large class of hedge funds don’t really offer the promise of beating the market? Well, look, the famous case here is mutual funds, where actively managed mutual funds, last time I looked at the data, had a negative return. Because the skill that’s being purportedly provided is less than the fee, even though the fee is just a 1 percent of assets under management. There you’ve got negative alpha. Why do people continue to buy exposure in these money-losing, actively managed mutual funds is because hope springs eternal, and people always think that they are investing in the top quintile of clever managers who are going to defy what the average does. People go to Las Vegas and gamble, even though they know that the house has better odds than they do as the punters. I think at a basic level, it’s not so surprising that people continue to invest in actively managed hedge funds because they’re a better option than actively managed mutual funds. The same would be true of actively managed venture capital, by the way. That’s part of the answer. The other odd part is that, as I was saying, over a long stretch of time, hedge funds have produced positive uncorrelated returns, which are good for a portfolio. The common way that this gets reported in newspapers, which is to say, “Look, the S&P went up 15 percent last year, and hedge funds only returned 4 percent, so hedge funds are a bunch of losers” — that is financially illiterate because you’re not comparing apples with apples. You need to compare what the alpha was in the two sets of strategy. By definition, the alpha in the S&P 500, the S&P 500 is the benchmark, so it’s a correlated return when the alpha was zero. What’s interesting is to get some uncorrelated return that then dampens your volatility in the rest of your portfolio because much of your portfolio will be correlated with the benchmark. If you can get this uncorrelated return, that will dampen the rest of your volatility, improve your risk-adjusted return in your total portfolio, and make your portfolio better. How did Ray Dalio become so rich?…

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