New research by the Alternative Investment Management Association (AIMA), in collaboration with Preqin, indicates that hedge funds have produced “more consistent and steadier returns than equities or bonds over both the short term and the long term.”
The study employed four scales of time: one year, three, five, and 10 years, and a database that included the returns of more than 2,300 individual hedge funds.
In the words of Jack Inglis, the CEO of AIMA, “We already knew that 2017 was a good year for hedge funds, with 11% return for the average fund and gains in every month of the year. But this new research makes an important contribution to the debate about hedge fund performance over the long-term since it shows that hedge funds have produced consistent and competitive returns for the last 10 years.”
He was seconded by Amy Bensted, the head of hedge fund products for Preqin, who said, “As our results show, hedge funds have proved their value within these investor portfolios over both the short and longer term.”
Considering just one year (2017), the Sharpe ratio of the S&P 500 (used as the equity benchmark) was 0.40. The Sharpe ratio for the Blomberg Barclays Global aggregate bond index was 0.18. But the Sharpe ratio for the Preqin All-Strategies Hedge Fund Index, which incorporates the aforementioned 2,300 funds, was 0.65.
To compare that with longer time scales, see the table below:
|All-Strategies Hedge Fund Index||S&P 500||Bloomberg Barclays Global Aggregate bond index|
|1 Year Sharpe ratio||0.65||0.40||0.18|
|3 Year Sharpe ratio||1.37||0.98||0.09|
|5 Year Sharpe ratio||1.58||1.46||0.24|
|10 Year Sharpe ratio||0.73||0.41||0.13|
Source: Preqin, AIMA
Critics of the Sharpe Ratio
The ratio used in that table is a measure designed by economist William Sharpe in 1966 to combine return and volatility (conceived of as a proxy for risk) in a single number.
S (x) = (rx – Rf) / StdDev (x).
The Sharpe ratio for X (which can be, for example, any of the three indexes included in the above table) is defined as the ‘excess return’ – the return in excess of what one could get risk free — divided by the volatility of the index or asset in question.
As the formula shows, we get the excess return simply, by subtracting from the average rate of return for x over the period in question (rx) the highest available rate of return on a risk free asset in the same period: Rf. We then divide that by the standard deviation for X.
Precisely because that is a simple calculation, the Sharpe ratio has become ubiquitous over the last 42 years. It has drawn some criticism, though, for its dependence upon the bell curve, or “normal distribution” (whence comes standard deviation). Critics like Nassim Taleb have long contended that bell curves are a mathematical convenience, not a real-world fact, and that reliance on Sharpe ratios can be dangerous in a world where the actual “tails” turn out to be fat ones.
Other AIMA News
In other news, on February 19 AIMA responded to a recent white paper from the U.K. Financial Conduct Authority.
The white paper, CP 17/40, “Individual Accountability,” proposed to expand the Senior Managers & Certification Regime (SMCR), a system created in 2013 that introduced specific responsibilities and conduct rules for listed management functions in the banking industry. Now, prompted by a 2016 act of Parliament, the FCA proposes to move other “relevant firms” under the coverage of the regime.
There is as of yet no firm timeline for the implementation of this reclassification, but for the purposes of the consultation paper, the FCA postulated that the SMCR would apply to controlled functions (CF) within insurers in late 2018, and to solo-regulated firms in mid to late 2019.
Of especial concern to AIMA is CF 4, which is the function of Partner, which includes members of an LLP, if the purpose of the entity is to carry on one or more of the activities regulated by the FCA.
In response, AIMA asks the FCA “to ensure clarity in the treatment of existing CF4 partners in the transition to the extended SMCR, in circumstances where certain partners will not meet the definition of a ‘senior manager’ under the extended SMCR.”