The results don't justify the hefty fees.
Everyone—consultants, advisers, funds of funds, capital introduction groups of prime brokers—recommends investing in hedge funds. Nobody is providing the opposite view.”
HOW DO HEDGE FUNDS GET AWAY WITH IT? EIGHT THEORIES
The other day, I asked how hedge funds manage to bestow such great riches on their managers despite the fact that, in many cases, their performance seems pretty ordinary. That got quite a reaction. The responses ranged from claims that hedgies are remunerated perfectly appropriately to charges that they are outright crooks who prey on gullible and greedy investors. Because the industry has grown enormously in recent years—according to one industry source, hedge funds now manage about $2.1 trillion of capital, a good deal of which comes from pension funds and charitable endowments—it’s not a trivial matter which of these explanations is the most accurate.
The crux of the issue is the industry’s two-tiered fee structure, which includes a hefty management fee (two per cent has long been the standard) and a big performance fee (twenty per cent is the standard). Here, again, is the question I posed. “Why do investors in hedge funds—the people whose money is at risk—continue to allow the managers of the funds to dictate such onerous terms to them?” I will consider various theories in order of plausibility, starting with the one that I consider least persuasive. Along the way, I’ll deal with some details that I didn’t have space for in my previous post.
1. They deliver superior returns. Several commenters said that it wasn’t fair to single out last year, when hedge funds generated a return of 7.4 per cent (net of fees), according to Bloomberg, and the S&P 500 produced an over-all return of about thirty-two per cent. Fair enough: let’s look at how investors in hedge funds have fared over a longer period.
According to the industry’s own figures, over-all returns have been falling steeply over the past decade or so. A study by KPMG, which was commissioned by the Alternative Investment Managers Association, an industry trade group, found that, between 1994 and 2011, hedge funds, on average, generated an average return of nine per cent. But Simon Lack, a financial consultant who used to work for J.P. Morgan and has written a skeptical book about hedge funds, points out that this figure disguises a sharp deterioration in recent years. Between 1994 and 1998, Lack points out in a presentation that is available online, the average return made by hedge funds was twelve per cent; between 2007 and 2011, it was just two per cent.
Even these figures aren’t necessarily reliable. They are calculated on the basis that each investor buys into a fund, or a range of funds, at the beginning of the period under study and holds on until the end, rebalancing his or her portfolio along the way so that the stake remains constant. But that isn’t how things work. Most investors buy in late, deploying and withdrawing big chunks of capital at irregular intervals. To take account of this behavior, Lack and others have redone the figures, calculating “dollar-weighted” rates of return, which provide a more accurate picture of how hedge-fund investors actually fared than the traditional “value-weighted” figures.
The difference this makes is quite substantial. According to Lack’s figures, between 1994 and 2011, hedge funds generated an annual return of six per cent rather than nine per cent. They did about the same as the stock market, which produced an annual return of 5.8 per cent, but not as well as bonds, which generated an annual return of 7.2 per cent.
An older study by Ilia D. Dichev and Gwen Yu, two academics who were then at the University of Michigan, produced broadly similar results. Dichev and Yu found that, between 1980 and 1992, when the hedge-fund industry was still very small, it generated an annual (value-weighted) return of 19.8 per cent—a very impressive figure. But, between 1993 and 2006, the annual rate of return fell to 11.1 per cent. These figures are for unadjusted value-weighted returns. When the authors converted them to dollar-weighted numbers, they found that hedge funds produced an annual return of twelve per cent between 1980 and 2006. That’s less than the annual return of 13.5 per cent that the S&P 500 produced over the same period.
The message from both studies is clear: hedge funds, on average, don’t outperform the stock market. In what sense, then, can their returns be considered superior? The next theory provides a possible answer.
2. They deliver superior risk-adjusted returns. O.K., an embattled consultant might say, hedge funds don’t necessarily beat the stock-market index over the long term, but they are much safer. They do, after all, have the word “hedge” in their names, and offer, as well as a sense of safety, decent returns.
The short answer to this is “2008,” when hedge funds, as an asset class, lost more than twenty per cent of their value. Some individual funds, such as Ray Dalio’s Bridgewater, which I wrote about at length in 2011, did well, but the industry as a whole did terribly. Just how terribly? According to Lack’s figures, hedge-fund losses in 2008 came to about four hundred and fifty billion dollars. That was considerably more than all the profits that the industry had generated in its entire history.
A statistician might argue that this isn’t a winning argument because, again, it focuses on one bad year. But that, surely, is the point. If hedge funds really are a hedge, rather than a way of trying to buy above-market returns, they should perform well precisely when everything else is going to pot. But they didn’t.
Here’s another way to look at it. If somebody offered you a costly investment that combined the promise of safety with the lure of attractive returns, how would you assess it? Well, one way might be to compare it to a hypothetical “sixty-forty” investment portfolio—sixty per cent stocks, forty per cent bonds—of the sort that regular investment advisers have been recommending to their cautious clients since the year dot. Lack carried out this exercise, looking at figures going back to 1998. In 2000 and 2001, when the dotcom bubble burst, hedge funds did what they are meant to do, he found: they outperformed the sixty-forty portfolio. But, in every year since 2002, including 2011, when the stock market was flat, the sixty-forty portfolio, which can be constructed very cheaply, did better than the average hedge fund.
3. They deliver uncorrelated returns. This is supposedly the sophisticated defense of hedge funds. By using a variety of techniques unavailable to ordinary folk, such as momentum investing, long/short investing, and betting on global macroeconomic trends or the outcome of mergers, they generate a special type of return, known as “alpha,” which is quite separate from the gains that can be reaped from more straightforward investments in various markets, known as “beta.”
Here we get into some complicated, contested, and almost theological debates. Rather than delving into them at length, I’ll confine myself to discussing a 2010 study that Roger Ibbotson, a finance professor at Yale, and two of his associates carried out. Defenders of hedge funds often cite it because it concluded that the funds do generate alpha on a consistent basis. “The positive hedge fund aggregate alphas for the last eleven years in succession suggest that hedge funds really do produce value,” the paper says.
Ibbotson and his colleagues start out by looking at the over-all peformance that hedge funds deliver. They calculate traditional value-weighted returns, rather than dollar-weighted ones, but they adjust them for a couple of other problems that are known to afflict hedge-fund data—the “survivorship bias” and the “backfill bias.” When these adjustments are made, it turns out that, between 1995 and 2009, hedge funds produced an annual average return of 7.63 per cent. Over the same period, the S&P 500 generated an annual return of 8.04 per cent.
This confirms that hedge funds don’t beat the stock market. How, then, can they be said to generate alpha? Ibbotson and his colleagues use a statistical model that seeks to explain the variability in hedge-fund returns on the basis of several variables, the most important of which are the market returns yielded by stocks, bonds, and cash. Broadly speaking, any returns that these variables can’t explain are attributed to alpha, and are thereby assumed to be generated by the skill and expertise of the hedgies.
Rather than discussing the pluses and minuses of this methodology, let’s look at the results that it generates, two of which stand out. The first is that most of the returns that hedge funds generate aren’t alpha at all: they’re beta in disguise. Of that annual average return of 7.63 per cent, 4.62 percentage points come from beta, and just 3.01 percentage points come from alpha, according to Ibbotson and his colleagues. Contrary to their P.R. pitch, hedge funds aren’t operating oblivious to market conditions. Like ordinary investors, the returns that they receive mostly come from simply being exposed to the market.
The second striking, if unsurprising, finding is that the fees hedge funds charge swallow up much of the alpha they produce. Gross of fees, the annual return to investors over the period from 1995 to 2009 was 11.42 per cent. Management and performance fees reduced this figure by 3.79 percentage points. Even if hedge funds are generating alpha, they are keeping most of it for themselves.
4. Low interest rates. In order to remain solvent, many pension funds need to generate annual returns on their investments of six to eight per cent. With interest rates as low as they have been in the past few years, investing in government bonds and corporate bonds doesn’t produce a high enough return. And investing in the stock market is rightly perceived as risky.
This environment has generated a demand for high-yield, low-risk investments, even among investment professionals who understand, on an intuitive level, that the very phrase “high-yield, low-risk investment” may well be an oxymoron. Hedge funds have seized upon this opportunity to present themselves as the solution to an urgent problem. Even though the industry slipped up badly in 2008 and individual funds have an alarming tendency to blow up or get into legal trouble, it still portrays itself as a safer alternative to the stock market. This marketing strategy may be working: in the first quarter of this year, according to a news release from Hedge Fund Research, the amount of assets that the industry manages hit a new high of $2.7 trillion.
In an article posted at allaboutalpha.com, Dan Steinbrugge, a hedge-fund consultant, explains why this is happening:
Most institutions are currently using a return assumption of between 4% and 7% for a diversified portfolio of hedge funds which compares very favorably to core fixed income, where the expected return is only 2.5% to 3.0%. As long as the expected return is higher for hedge funds than fixed income, we will continue to see money shift from fixed income to hedge funds.
5. Lack of transparency.
