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The Fiduciary Standard Is Far From Enough

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As I write this column, the Department of Labor (DOL) is expected to release a new rule any day now which would apply to all retirement assets and which would make advisors giving advice with respect to such assets fiduciaries, would prohibit conflicts of interest and would eliminate commissions on related transactions except for some very limited exceptions.

President Barack Obama wants this new rule to implement what he sees as consumer financial protections and to combat what he sees as abusive practices by the financial industry that predated the 2008 financial crisis. The president views this proposal as crucial to his legacy.

Despite significant industry and political opposition, I fully expect that a DOL fiduciary standard will be released shortly, perhaps even before this column reaches print, and that it is likely to be implemented, most likely late this year.

It is also likely that the Securities and Exchange Commission (SEC) will propose a fiduciary standard of its own, perhaps this year as well. It is not yet entirely clear what these rules will ultimately look like, how comprehensive they will be and how the DOL and SEC rules might intersect.

Still, it is clear that the financial advice business seems likely to change and to change a lot in the very near future. Moreover, despite some substantive problems with the current proposal, it seems impossible to argue with the idea that financial advisors should have to put the interests of their clients first.

Misguided Mandates

That said, while a fiduciary standard should help to make the financial advice industry more accountable, it will only work indirectly to mitigate the biggest issue consumers face in this area — the overall competence of the financial advice business.

In large measure because the barriers to entry into the business are so low (essentially no educational requirements and very low licensing hurdles), there are way too many financial advisors working with clients who simply don’t have the expertise needed to do it well. Perhaps worse, they often think they are in fact doing what is best for their clients when they are doing anything but.

Charlie Bilello of Pension Partners recently published a list of mandates for hedge funds put together by consultants for their investor clients that included those listed below. Remember that these consultants make their living due to the alleged value they add to their clients via manager selection. Oh, and they are typically held to a fiduciary standard.

  • “Its strict requirement is that funds must have at least three years of 15% returns. The ratio of annual returns to maximum drawdown must be at least 1.5.”

  • “The expected return of the manager is typically between 12% to 15% on a five year annualized basis. Managers with a maximum drawdown of 20% or more will be not considered.”

  • “Expects a return of 10% to 15% and drawdowns of no more than 5% to 10%.”

  • “The firm generally targets returns of 15% and volatility should be 7%.”

  • “Currently looking for energy hedge fund managers with net returns greater than 20%. Managers should have the ‘right pedigree’ and not have a drawdown of greater than 15%.”

  • “The firm is only interested in funds that have track records between six and 18 months with Sharpe ratios of 1.25 or greater. The firm does not wish to review managers that have had drawdowns of greater than 6%.”

These expectations are literally ridiculous — worthy of ridicule or derision; absurd; preposterous; laughable. Yet, as Bilello emphasizes, these are all “institutional” allocators who are alleged to be the “best of the best” in terms of picking hedge fund investments.

To the extent that there are hedge funds meeting these criteria, making allocations to them would almost certainly be performance-chasing at its most blatant.

The research is crystal clear that “if past performance is used at all for hiring and firing managers it is the best performing managers that should be replaced with those who have performed more poorly.” (See Cornell, Hsu & Nanigan, “The Harm in Selecting Funds that Have Recently Outperformed,” 2016). When mean reversion rears its head, the results likely won’t be attractive.

Hedge funds are particularly problematic because their performance has been so poor overall. As Simon Lack demonstrated in his book “The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to Be True,” if all the money ever invested in hedge funds had been placed in U.S. Treasury bills instead, the net result would have been about twice as good for investors (if painful for hedge fund managers, who have made a fortune on their unfortunate investors).

Simple benchmarking tells the same story. Since the beginning of 2005, the period over which the overwhelming majority of hedge fund investments have been made, the HFRX Global Hedge Fund Index and HFRX Equity Hedge Index (two investable indices widely used as benchmarks in the industry) have posted negative returns while the Barclays Aggregate Bond Index and the S&P 500 Index (along with nearly all major bond and stock indices) are up dramatically.

None of this is to suggest that no hedge funds are any good. But it is important to recall that size is always the enemy of performance. With over 10,000 hedge funds managing nearly $3 trillion in assets now and nearly all managing those assets in roughly the same manner, the hedge fund trade is a very crowded one indeed.

Name Your Preferences

Yet the mandates — from people who should most certainly know a lot better — keep coming. As the outstanding analyst Tom Brakke points out, “the striking thing about the list of mandates provided is the unrealistic notion that you can name your preferences for return, volatility, drawdown or Sharpe ratio and go out and find someone who can produce it.

What that leads to is the selection of a manager who has apparently produced those numbers in the past. Good luck with that.”

All the available performance data corroborate Brakke’s skepticism. For example, in addition to what I have outlined above, one study over two decades of nearly 600 pension funds each with assets of roughly $10 billion on average showed that they too engaged in performance chasing, even though they were managed by people with a fiduciary duty to them.

They over-weighted stocks going into a downturn and under-weighted them going into a recovery, missing out on the upcoming mean reversion and failing adequately to manage risk.

Another study of roughly 90% of the investment consulting market found “no evidence that consultants’ recommendations add value to plan sponsors.” In fact, actual performance was worse even before accounting for the fees charged by the consultants (who were, once again, most typically fiduciaries).

Of course, more prosaic investment choices all too frequently make the same outsized claims with similar and all-too-predictable results. As Morningstar’s Jeffrey Ptak has shown, recent rolling seven-year mutual fund excess gross returns by active managers (those who set out to “beat the market”) are the lowest we’ve seen in two decades.

The average fund generated a measly 12 basis point gross excess return — before fees! — in the seven-year period ended Nov. 30, 2015. Add fees into the calculation and it’s no wonder that the annual S&P SPIVA scorecard so routinely shows such wide and deep investment underperformance throughout the mutual fund industry.

As I argued last month, much of the money management business has been an abject failure pretty much across the board. Poor investor behavior makes that dreadful performance even worse — consumers trade too often, at the wrong times and into the wrong instruments. They chase returns via managers, sectors and trades that have been hot, only to be disappointed when mean reversion inevitably sets in.

Their inflated expectations make matters worse still, because investors expect outperformance as a matter of course and investment managers tell them to expect it, implicitly and explicitly.

That’s what makes the sale after all. A 2012 study from the National Bureau of Economic Research concluded that financial advisors reinforce behavioral biases and misconceptions — the problems outlined above — in ways that serve the advisors’ interests rather than those of their clients.

None of these huge problems is likely to get fixed via the implementation of fiduciary standards of care by the DOL and the SEC, well intended though they are. The overall practice standard needs to be much higher and it must start with much higher educational and training requirements.

To repeat my assertion from last month’s column, proper financial advisor priorities begin with a recognition of what is important and what is achievable. Clients and prospects routinely have unreasonable expectations. But they are just as routinely egged on by financial advisors whose own claims and expectations are just as outlandish. The outrageously silly expectations of the consultants described above make the point beyond dispute.

No matter what the DOL and the SEC choose to do or not do in this regard, true success for both advisor and client will require carefully and truly doing the right thing, even when the client doesn’t see it that way. Doing so demands not just a higher standard of care, but also a much higher standard of practice. It should be axiomatic that a higher practice standard will require much higher training and educational standards. Fiduciary standards won’t hurt in that regard, but they aren’t nearly enough either.


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