One of my all-time favorite movies is Real Genius. The 1985 Val Kilmer flick follows nerdy high schooler Mitch as he ascends into a wunderkind academic program at the fictitious Pacific Technical University and partners with physics legend Chris Knight (Kilmer) to construct a six-megawatt laser.
The movie is filled with sarcastic one-liners, saucy double entendres, and a closet-dwelling supergenius named Lazlo Hollyfeld. Of course it also features both a professorial supervillain named Jerry Hathaway, in league with the CIA to weaponize said laser, and bumbling villain-wannabe Kent, best remembered for having conversations with God through his braces.
As Mitch and Knight race to complete the laser so Knight can graduate, Kent sabotages the optics, causing the laser to melt down. This setback, however, leads Knight to a pivotal breakthrough. When Lazlo asks him how he did on his exams, Knight exclaims: “I passed, but I failed! Yeah!” To which Lazlo responds: “Well, then I’m happy and sad for you.”
It ends happily, as most ’80s films did, after Knight and company discover the CIA plot and use the laser to destroy itself and Jerry’s new home in a flood of popcorn. With Tears for Fears playing in the background, it has to be one of the best movie endings of all time.
But it’s the exchange between Lazlo and Knight that I still find intriguing today. F. Scott Fitzgerald wrote, “The test of a first-rate intelligence is the ability to hold two opposing ideas in mind at the same time and still retain the ability to function.” I passed, but I failed. I’m happy and sad for you. The ability to embrace contradiction is the mark of a truly smart cookie.
Which is why I was so pleased to see the results of J.P. Morgan’s 2017 Institutional Investor Survey of hedge fund investors last week. Based on responses of 234 institutional investors — consultants, endowments, foundations, family offices, funds of hedge funds, pensions, and so on — representing roughly $750 billion in assets under management, the survey determined that three quarters of the investors polled were disappointed in hedge fund returns in 2016. As a longtime participant in the alternative-investment industry, why would I find this news comforting? Because at the same time that 75 percent of investors expressed dissatisfaction with hedge fund performance, 67 percent of investors indicated that they intend to maintain their hedge fund allocations, and an additional 20 percent plan to invest more with hedge funds going forward.
Like Lazlo, this makes me both happy and sad for the investors polled. Why? Of course I’m sad that returns aren’t colossal — my mom is a retired teacher on a pension, so I know exactly what the stakes are in this race. But I’m also happy, because these survey results demonstrate a fundamental understanding of how hedge funds are designed to work. Because they are (or are supposed to be) hedged, it is highly unlikely that hedge funds would consistently outperform a strongly upward-trending market. Investors apparently realize, however, that whatever “underperformance” comes from comparing returns with an unhedged benchmark isn’t inherently an indicator of a broad performance issue. It is instead the nature of the beast.
Hedge funds, in this case, are like insurance. Most of us hate paying insurance premiums when we’re well and only go to the doctor once or twice in a given year, but we’re sure glad to have coverage in the event of catastrophic illness or accident. And while investors haven’t had to exercise their insurance policy since 2008, it seems they do understand that this doesn’t mean they won’t ever need it in the future.
I’m also delighted because these results imply that the hedge funds selected by the investors are, at least to some degree, sticking to their knitting. When I first started in this industry in the late 1990s, too many hedge funds, made giddy by one of the greatest bull markets in history, were drifting ever more long-biased. Soon some were 90 percent or more net long, or had just token hedges in the form of Standard & Poor’s 500 stock index options. When the tech wreck hit in 2000, many investors found their hedge fund “insurance policies” sorely lacking or simply gone.
I am a bit saddened, however, if the investors in question only matched the HFRI Fund Weighted Composite Index performance of 5.57 percent or, worse still, underperformed that number. There are a host of hedge funds that have beaten that bogey but, because they may not be part of the billion-dollar club, are routinely overlooked by many institutional investors. And although these funds may not have boosted returns to the stratospheric level of the S&P 500 over the past eight years, they likely could have made the insurance policy just a bit cheaper.
Clearly, hedge funds continue to face an uphill battle with many investors when it comes to performance, fees, liquidity, indexing, and other factors in 2017. But for the time being I think it’s safe to say that, like Chris Knight, hedge funds both passed and failed in 2016, and many investors seem okay with that level of contradiction for now. How funds fare when the fit hits the shan will truly determine if accepting the cognitive dissonance was worth it.
