There's nothing more dangerous than knowing a little economics. Just ask hedge funders.
The past four years have been a great time for investors, but not for hedge funds. While the S&P 500 has rallied more than 140 percent from its March 2009 lows, the supposedly smart money hasn't made nearly as much of it. Hedge funds, as a whole, haven't beaten the market -- and they charge investors 2 percent of all assets, and 20 percent of all profits (if there are any) for this privilege. Indeed, in 2012, big-name managers Ray Dalio and Steve Cohen made $1.7 billion and $1.4 billion, respectively, despite lagging the S&P 500. Not bad work, if you can get it.
But hedge funds haven't just been a sucker's bet for the past five years. It's been more like ten. As you can see in this chart from The Economist, a 60-40 equity-bond index fund would have returned over 90 percent the past decade. Hedge funds would have returned just 17 percent, after fees.
Why can't the masters of the universe master a simple index fund? Well, markets are efficient-ish, and there are only a handful of people who can consistently beat them. But that's not what they think is going on. They think a certain Princeton economics professor is to blame. (No, not Paul Krugman).
As Joe Weisenthal points out, the recent Ira Sohn Investment Conference hasn't just been a confab for hedge fund bigwigs; it's been a never-ending two minutes of hate for Ben Bernanke. Now, the Fed Chairman might seem like an odd target for big-money bile, and he should. If nothing else, quantitative easing has propped up equity prices the past few years -- but that apparently isn't what hedgies want. Why? A few theories. For one, as Weisenthal argues, most hedge fund managers today came of age during the 1970s, back when inflation was real and not bogeyman, and they can't shake their fear of what they think is easy money. For another, they (mostly) don't understand that the rules change when the economy is in a liquidity trap. Or, as Krugman puts it, they don't like that they keep being wrong, and a bearded academic like Bernanke (or somebody else for that matter) keeps being right.
In other words, they don't get Keynesianism.
The biggest mistake an investor can make today is not realizing it's Keynes' world, and we're all just living in it. Now, in normal times, there's a straightforward relationship between money and prices: the more of the former, the higher the latter. (Indeed, Keynes wrote about this before he invented Keynesian economics). But these aren't normal times -- interest rates are stuck at zero. When cash and bonds are close substitutes -- both yield nothing -- printing money won't increase inflation. It won't do anything. New money will just pile up in the banks as excess reserves. That's exactly what you can see in the chart below: reserves have gone up over 1,000-fold the past five years, but prices haven't even gone up 10 percent.
But hedge funders see something different in this chart. They see the canary in the hyperinflationary coal mine. They figure the banks will eventually lend out these $1.8 trillion of reserves, and this will make prices explode. Or, alternatively, they think the Fed will soon have to start hiking interest rates (including interest on reserves) to head off such a stagflationary nightmare. In other words, they can't imagine that quantitative easing won't end in tears: as either a rerun of the inflationary 1970s or the bond massacre of 1994. And they think this is the next black swan.
Remember, the promise, and allure, of hedge funds is that they can deliver outsized returns. That's why they can charge such outsized fees (though maybe not for long). It's about identifying major market mispricings. That's what hedgies who shorted the housing bubble found, and that's what hedgies who went long inflation or short bonds thought they had found.
Let me conclude with a gift suggestion for that hedge fund manager who has it all. Ubiquitous fund-of-funder Anthony Scaramucci says middle-aged white men adore the band Train. But there's a better way to spend $90 than on a soft-rock concert. It's a Paul Krugman textbook.
"Hey Soul Sister" has nothing on the IS-LM model.
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Matthew O'Brien is a former senior associate editor at The Atlantic.