Hedge Funds: Not So Glamorous After All
When thinking of elite investment vehicles, many people think of hedge funds. For the most part, hedge funds are largely unregulated because they cater to sophisticated investors. In the U.S., laws require that the majority of investors in the fund be accredited. That is, they must earn a minimum amount of money annually and have a net worth of more than $1 million, along with a significant amount of investment knowledge. You can think of hedge funds as mutual funds for the rich. They are similar to mutual funds in that investments are pooled and professionally managed, but differ in that hedge funds have far more flexibility in their investment strategies. It seems natural to infer that managers with little restrictions in investment strategies handling the money of the wealthy should be amongst the best in the industry. They should be able to prove that they consistently beat the market and generate outperformance.
Evidence Against Hedge Fund "Outperformance"
There are many studies on hedge funds and their performance. Let me cite three studies that prove that hedge fund managers do not provide investors with excessive returns.
Study 1: Offshore Hedge Funds: Survival and Performance 1989-95
This study by Stephen J. Brown, William Goetzmann and Roger Ibbotson looked at hedge funds from 1989 to 1995 to see how their performance compared to their benchmarks and the S&P 500. The popular perception is that offshore hedge funds experience high returns at considerable risk. The study found that hedge funds value weighted return actually beat the market since 1990. However, the attrition rate of hedge funds is around 20%. This gives a large upward bias to the performance of the funds. When taking this implied survivorship bias into account, we find that the average annual offshore hedge fund return was 13.26 % from 1989 through 1995, compared with the S&P 500 return of 16.47% over the same period.[i]
Figure 1: Stephen J. Brown, William N. Goetzmann, and Roger G. Ibbotson, “Offshore Hedge Funds: Survival and Performance, 1989-95,: Journal of Business, January 1999:98.
Study 2: The A, B, Cs of Hedge Funds: Alphas, Betas, and Costs
This study attempted to determine what portion of hedge fund returns can be attributed to alpha and beta. Alpha is the excess return of the fund relative to the return of its benchmark. Beta is how much the fund correlates to its benchmark. The study took into account survivorship bias and backfill bias (entering a database only after a period of good performance). Here’s a conclusion of their findings:
For the equal-weighted index of hedge funds, we estimated a pre-fee return of 11.13 percent, which consisted of fees of 3.43 percent, an alpha of 3.00 percent, and beta returns of 4.70 percent. The alpha estimate was statistically significant at the 5 percent level. All nine subcategories of funds had positive alphas, and the alphas of four of the subcategories were statistically significant.[ii]
What this is saying is that the average fund had an annual return of 7.7%. Collectively hedge funds have produced positive alpha every year since 1995 except for one year, 1998. This seems to be great news for investors. The track record of positive alpha means that the managers seem to have some skill in beating the market. However, one must take into account the fees associated. The average fund charges 1-2% annually, then a 20% performance fee if the fund does well enough. With the fees included, hedge funds collectively underperformed the S&P 500 by 3.9% annually from 1995-2006.[iii] This included the bear market of 2000-2002 in which hedge funds are supposed to perform best.
Study 3: Hedge Fund Performance 1990-2000: Do the “Money Machines” Really Add Value?
This study attempts to investigate if hedge funds return superior returns based on the risk level of their investments. Other studies that attempt to answer the same question (The A, B, Cs of Hedge Funds) use traditional performance measures such as the Sharpe ratio and alpha. The conclusion from this type of research is that hedge funds do indeed generate superior performance. However, research has shown that hedge funds exhibit a high degree of non-normality in their distributions and have a non-linear relationship with the stock market. This makes the use of traditional performance measures questionable. Thus, this study uses a new dynamic trading based performance measure that does not require any assumptions about the distribution of fund returns.[iv] The study covered 13 hedge fund indexes and 77 individual hedge funds.
Here’s a summary of the findings[v]:
12 out of the 13 indexes studied showed signs of inefficiencies that amounted to around 3% a year. This means that the same returns could have been achieved with much less risk
72 of the 77 funds studied had an average efficiency loss amounting to 7% a year. The other 5 funds offered superior performance with an average efficiency gain of 1.5% a year.
The type of hedge fund (event-driven, global, or market neutral) did not matter when it came to being efficient.
The authors reached their conclusion that hedge funds do not generate superior return even without taking into account the significant survivorship bias. In fact looking at the HFRX Index, one can see that it did not only underperform major equity classes, but also underperformed the fixed income indexes. Problems with Hedge Funds
There are many reasons why hedge funds underperform.[vi]
Liquidity Issues: Investments in hedge funds are illiquid as they often require investors keep their money in the fund for at least one year, a time known as the lock-up period. Withdrawals may also only happen at certain intervals such as quarterly or bi-annually. Evidence shows there has not been any additional compensation for this incremental risk.[vii]
Lack of Transparency: Hedge funds lack transparency making it hard for investors to assess the risk profile.
Non-normal Distribution of Returns: Hedge funds exhibit negative skewness and high kurtosis (= fat tails on the left of the distribution = high-loss scenarios). This means that hedge funds have the characteristics that risk adverse investors dislike the most.
Risk of Dying: The risk of a hedge fund shutting down is enormous. A study by Greg N. Gregoriou found that the median residual lifetime of a fund is just 5.5 years.[viii] A great example is Meredith Whitney. In 2007 she made some well-timed predictions and gained fame for her analysis. As a result she started her own firm and subsequently a hedge fund - Kenbelle Capital - believing her success was due to her skill as a market-beating investment analyst. By 2015 (2 years after the inception of her fund), she shut down her hedge fund as a result of heavy losses.[ix]
Riskiness of the Assets: A study by AQR Capital Management found that many hedge funds were taking on additional risk by investing in illiquid securities.[x] Also, many hedge funds use leverage to try and enhance returns. Alphas reported by the hedge funds are misleading as they use inappropriate benchmarks.
Tax Inefficiencies: Due to high turnover rates, hedge funds produce returns in a tax-inefficient manner.
Agency Risk: If a manager is nearing the end of the period and hasn’t reached the predetermined benchmark level he or she may take on additional risk to attempt to beat the benchmark. There’s a second type of agency risk. A high water mark means that a fund with negative performance cannot collect its incentive pay until it “makes up” the negative performance. Thus, the second type of risk comes in when a fund has consecutive bad years. Since the chances of earning incentive pay are small at this point, the manager can choose to shut down the fund and restart a new one effectively resetting this high water mark.
Biases in the Data: There are four main biases when hedge funds report their performance. There is survivorship bias, backfill bias, self-selection bias, and liquidation bias. We have mentioned survivorship and backfill bias above. Self-selection bias is when poorly performing funds choose not to report data. Liquidation bias is when defunct funds fail to report their last returns. The combination of all these biases combined approach a negative portfolio drag of 10%. But truth be told, it is rather exceptional that a single hedge fund exhibits all of these biases concurrently to their respective maximum loss-making extent.
Hedge funds do not provide the appropriate amount of return for the risk they take on. Hedge fund managers are supposed to be some of the best in the world. They essentially have free reign on the types of investments they can make and handle the money of the wealthy, sophisticated investors. Why would an affluent investor place trust in anyone but the best managers?
Hedge funds may seem great. They report excellent returns and claim to generate alpha. However, once you take into account the risks and biases in hedge funds, you find that they are only glamorous from the outside. But, one has to admit that hedge funds are excellent vehicles to enrich oneself, but only if one is the owner and/or manager of said hedge fund!
Sources: [i] Stephen J. Brown, William N. Goetzmann, and Roger G. Ibbotson, “Offshore Hedge Funds: Survival and Performance, 1989-95,: Journal of Business, January 1999:98.
[ii] Roger G. Ibbotson and Peng Chen, “The A, B, Cs of Hedge Funds: Alphas, Betas, and Costs,” Working Paper (September 2006)
[iii] Swedroe, Larry E. The Quest or Alpha. Hoboken: John Wiley & Sons Inc., 2011
[iv] Harry M Kat and Guarav S. Amin, “Hedge Fund Performance 1990-2000: Do the ‘Money Machines’ Really Add Value,” Working Paper (July 2002).
[v] Swedroe, Larry E. The Quest or Alpha. Hoboken: John Wiley & Sons Inc., 2011
[vi] Swedroe, Larry E. The Quest or Alpha. Hoboken: John Wiley & Sons Inc., 2011
[viii] Greg Gregoriou, “Hedge Fund Survival Lifetimes,” Journal of Asset Management, December 2002.
[x] Ken Brown, “New Study Snips Away at Hedge Funds,” Wall Street Journal, February 22, 2001.