A new analysis concludes that over the period 1994-2011 the average annual return on a hedge fund investment, after fees, was 9.07 percent. This is superior to the return for equities, bonds, or commodities. Further, the more directional strategies within the hedge fund world produced the highest returns.
The analysis, performed by the Imperial College’s Centre for Hedge Fund Research, was sponsored by both the accounting/auditing giant KPMG and the Alternative Investment Management Association. It goes beyond fixing performance figures to discuss the distribution of that gain: roughly 28 percent went to the hedge fund managers, the remaining 72 percent to the investors.
Numbers Speak for Themselves
“The most interesting point to come out of this research is that it disproves common public misconceptions that hedge funds are expensive and don’t deliver. The strong performance statistics, showcased in our study, speak for themselves,” according to Rob Mirsky, head of Hedge Funds at KPMG in the U.K, quoted in a press release accompanying the study.
The analysis looks explicitly at the place of hedge funds within a portfolio, and documents that “an equal weighted portfolio containing hedge funds, stocks and bonds has significantly higher performance with lower tail risk than a conventional portfolio based on the 60/40 allocation of stocks and bonds.”
As you can see from the above graph, hedge fund returns (the red line) tracked very close to global stocks (blue) from 1994 to 1999. Thereafter global stocks headed down for three years, during which years hedge fund performance went, at worse, sideways. Both lines start a steady upward move again in 2002, and the difference between them remained roughly constant until 2007-08, when the global financial crisis did more injury to stocks than to hedge funds. Since then, the two asset classes have resumed parallel upward tracks, but the distance is considerable.
Another intriguing feature of that graph: it shows that over this period global stocks did not produce a premium over global bonds (compare blue and yellow lines). Bonds look like the turtle in their race with rabbity stocks, and at the 2011 finish line yellow is just a bit above blue.
As one would expect, distinct hedge fund strategies yield distinct results. Long/short equity strategies (or “equity hedge” as KPMG calls them) have done best. Generally speaking, hedge funds willing to make directional bets have outperformed those that stick to relative-value plays.
Profit Sharing and Correlations
In their explanation of the distribution of the gains from hedge funds, the study’s authors assume an average management fee of 1.75 percent and an average performance fee of 17.5 percent. They find that annualized gross returns during the period in question are 12.61 percent. This breaks down into 9.07 percent for the investors, or 71.93 percent of the whole.
The study indicates that hedge funds offer valuable diversification as well. Such funds exhibit a negative correlation to global bonds (-0.06) and a positive but respectably low (0.41) correlation to commodities.
It must be said though, that the correlation of hedge funds with global stocks is rather high (0.80).
The study also observes that correlations between the other asset classes and hedge funds are in general only slightly higher during recessions than they are at other times. This runs counter to suggestions that hedge funds “threaten the stability of the financial system.”
Correlations between hedge funds and various asset classes vary wildly from year to year. As the graph below indicates, for example, the rolling 12-month correlation between global bonds and hedge funds (the blue line) was above 0.5 at the beginning of the period under study, sank well into negative territory in 1995, and returned to the neighborhood of 0.5 again in 1996. The zigzagging continued for some time, but this correlation has been consistently negative since early 2009.
When they consider the correlations by individual hedge fund strategy, the report’s authors suggest that market neutral, CTA, and macro styles, though not the highest-return strategies, “may provide diversification benefits when they are needed the most.”
When stock markets globally “faced a significant drawdown” in the months December 2007 and January 2008, short bias funds performed their diversification role almost perfectly; their correlation came very close to -1.0.
On an academic note, this study’s results as to hedge fund performance aree in general consistent with the 7-factor model developed by William Fung and David Hsieh in 2004.