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A Hidden Risk You Never Saw Coming

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Ken Griffin is a hedge fund manager with an enviable net worth of $7 billion. According to published reports, he recently settled a contentious divorce dispute with his wife, Anne Dias Griffin, shortly before it was scheduled to go to trial.

There was a lot at stake. His wife claimed Griffin earned an unbelievable $100 million a month!

Why should you care?

Marital events can adversely affect returns

I don't understand the fascination that investors, including pension and endowment funds, have for hedge funds. As my colleague, Larry Swedroe, noted, for the 10-year period from 2005-2014, the HFRX Global Hedge Fund Index underperformed every major stock and bond asset class.

You might think this data would dissuade most investors. Clearly, this is not happening. According to data from the HFR Global Hedge Fund Industry Report, investors allocated $21.5 billion in net new capital to hedge funds in the second quarter of 2015. Total hedge fund assets globally are $2.97 trillion.

If historical underperformance isn't enough, a recent study adds another concern. The study examined 31,542 hedge funds, 18,295 of which were "live" and 13,247 of which were "dead." It found that hedge fund managers significantly underperform while undergoing a divorce. The underperformance is significant. In the six-month period surrounding a divorce, hedge fund managers underperform by 4.33 percent per year compared to the pre-divorce period. During the same six-month period, fund alpha declined by 7.39 percent per year.

Moreover, this underperformance persisted beyond that six-month period. The funds continued to underperform by a risk-adjusted 2.29 percent per year up to two years post-divorce.

That's already pretty bad, but it gets even worse. The study also found that, during the six-month period surrounding a marriage, "fund alpha falls by 8.50 percent per annum." Both marriage and divorce, it appears, are major life events that distract hedge fund managers from their focus on investments.

Effects of distraction

The authors of the study found the distraction of marriage and divorce caused hedge fund managers to make fewer investment decisions. They were more likely to mimic the risk loadings of their "investment style peers" and to increase their allocation to stocks in the S&P 500 index.

Distracted fund managers also made poorer investment decisions and exercised less discipline. They were more likely to hold onto their losses and realize gains during periods in which they were distracted.

Ramifications of this study

While this study was limited to hedge funds, the findings could have far-ranging implications. Do they apply to all actively managed funds? What about alternative investments? Do they apply to brokers and financial advisors? What about other major life events, like the birth of a child? What about other traumatic events, like a health crisis, death of a loved one or the divorce of a close relative?

Evidence-based investors don't have to worry much about these issues. Most of the work managing index funds is computer based, since the mandate of such funds is simply to track the returns of the benchmark index.

If you need another reason to abandon active management, maybe the potential for your fund manager to be distracted by life events will be the tipping point.

2015-10-13-1444769042-5195634-SmartestInvestment.jpgDan Solin is a New York Times bestselling author of the Smartest series of books, including The Smartest Investment Book You'll Ever Read, The Smartest Retirement Book You'll Ever Read and his latest, The Smartest Sales Book You'll Ever Read.

The views of the author are his alone and may not represent the views of his affiliated firms. Any data, information and content on this blog is for information purposes only and should not be construed as an offer of advisory services.

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