Don’t Fear Hedge Funds or Directional Strategies

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.

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3 Comments

  1. Joyce
    May 24, 2012 at 12:36 pm

    Two words. Survivor bias.


  2. Simon Lack
    May 24, 2012 at 4:33 pm

    Hedge funds have received quite a battering in the financial press of
    late. Persistently disappointing results have rightly drawn attention
    to the high fees, opaque strategies and limited liquidity that
    characterize much of the industry. My recent book, The Hedge Fund
    Mirage, has helped promote a long overdue debate about how investors
    should access some of the most talented money managers around.
    Although in aggregate all the money ever invested in hedge funds would
    have been better off in treasury bills, there are and probably always
    will be fantastic managers and happy clients. However, in recent years
    these have increasingly become the exception.

    Although this description of hedge funds is provocative, much of the
    industry has sensibly kept its head down. In fact, few managers
    promote the industry and most are focused simply on their hedge fund.
    Many insiders readily acknowledge the disappointing results of the
    past with little surprise. However, the Alternative Investment
    Managers Association (AIMA), a UK-based lobbying group, has come to
    the defense of hedge funds. They recently commissioned a report titled
    “The value of the hedge fund industry to investors, markets, and the
    broader economy” in partnership with KPMG and the Centre for Hedge
    Fund Research at Imperial College, London. Although the paper
    concludes by noting the substantial social benefits of hedge funds
    such as employing 300,000 people globally, generating £3.2 billion in
    UK tax revenues and their stewardship of assets for “socially valuable
    investors”, I’m just going to focus on whether hedge funds have been a
    good deal for their clients.

    Asset weighted returns, or the return on the average dollar, are poor.
    My analysis shows in aggregate treasury bills were a better bet. I
    found this to be the case only through 2010, and while some may
    torture the data to produce modestly different results, 2011 was the
    second worst year in history for hedge funds and should pretty much
    end the performance discussion.

    Average annual returns are good. The KPMG/AIMA study referenced above
    finds that an investment in an equally weighted portfolio of hedge
    funds starting in 1994 (as far back as data can reasonably be sourced)
    generated an annual return of over 9%, handily beating stocks, bonds
    and commodities. Returns in the 90s were good for the small number of
    investors participating. The 9% figure is the average over 18 years.
    The question is whether the 12.4% return from 1994-98 is just as
    important as the 2.6% return from 2007-11, when the industry was
    twenty times as big.

    Hedge fund investors know that small hedge funds outperform big ones;
    they also know that most big hedge funds they look at performed better
    when they were smaller. What is true for most individual funds is true
    for the industry as a whole. Using an equally weighted portfolio to
    represent returns will be upwardly biased for this reason. An equally
    weighted S&P500 has outperformed the cap-weighted version too. While
    equal weights might be a good way to invest, it’s clearly not a
    strategy available to all investors, since hedge funds are not equally
    sized. The return enjoyed by a hypothetical investor who started in
    1994 investing equal dollars in each hedge fund isn’t representative
    of the average investor and is more marketing pitch than analysis.

    Given how poorly actual hedge fund investors have done how could new
    investors possibly think that they will make money going forward? To
    do so they must accept the returns of a hypothetical investor who
    invested equal dollar amounts in hedge funds and maintained those
    equal investments in each hedge fund every year since 1994! As I
    point out in The Hedge Fund Mirage performance was better both for the
    industry when it was smaller and for individual hedge funds when they
    were smaller.

    Fees are egregious by any measure. The 2% management fee and 20%
    incentive fee have resulted in an enormous transfer of wealth from
    clients to the hedge fund industry. My analysis shows that pretty much
    all the profits earned by hedge funds in excess of the risk free rate
    have been consumed by fees. Anybody with a spreadsheet can calculate
    this using publicly available data without great difficulty. KPMG/AIMA
    concede that hedge funds have garnered 28% of investor profits,
    although treasury bills averaged 3.2% over this same period so even
    using their own numbers reveals that in fact fees took 64% of the
    returns in excess of the risk free rate. This is for the hypothetical,
    equally weighted portfolio begun in 1994. It also ignores netting –
    winning hedge funds charge an incentive fee whereas losing managers
    don’t offer a rebate. By treating the industry as one giant hedge fund
    it ignores the fact that whenever an investor holds some losing hedge
    funds his effective incentive fee will be higher than the typical 20%
    of profits. Without doubt, for the actual universe of investors whose
    hedge fund investments performed worse than the hypothetical investor,
    fees have consumed all the profits.

    Those who think the first five years of hedge fund history are as
    important as the last five will hold out hope for that 9% historic
    return. Even a 7% return on hedge funds, the typical expectation of
    many investors, represents $140 billion in annual profits (net of
    fees, naturally) on the approximately $2 trillion in AUM. It’s a
    figure the industry has never generated other than in 2009 following a
    $450 billion shellacking in 2008. Generating $140 billion of
    uncorrelated, absolute return every year (after fees) has proved to be
    a bridge too far. Hedge funds are over-capitalized.

    AIMA would better serve its constituents by promoting transparency,
    improved governance and fee structures that are commensurate with a
    world of near zero interest rates. Instead the 2&20 crowd has spent
    some of their fees on a glossy marketing brochure. By promoting the
    status quo they’re ignoring the experience of hedge fund clients, who
    are struggling with the reality of continued poor results delivered at
    great expense. Institutions such as Allstate Insurance, whose global
    head of hedge funds Chris Vogt recently said, “This is a make-or-break
    year for hedge funds” will increasingly force change on the hedge fund
    industry, to the undoubted benefit of the clients hedge funds are
    supposed to serve.

    From my blog, blog.sl-advisors.com, The Hedge Fund Lobbyists Fight
    Back, April 26, 2012


  3. Sidsel
    June 7, 2012 at 2:57 am

    Four words actually:
    Survivorship bias and self reporting


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