Are hedge funds losing their edge?

Hedge funds are a boutique segment of the investing world, usually marketed to large institutions and wealthy individuals (not to the general public). As the name implies, many of these funds combine a somewhat more risky overall strategy, operated by highly professional traders, with a relatively safer “hedge.” Together, these two balancing strategies seek overall returns exceeding more conventional investments with less susceptibility to losses during periods of higher volatility. Worldwide, hedge funds manage roughly USD$3.2 trillion in assets.

Hedge funds typically charge a management fee of around 2 percent, and a performance fee (a take on profits) of around 20 percent. These fees are at the opposite end of the spectrum from exchange-traded index funds, whose management fees are as little as 0.05%, with no take on profits. The index fund strategy, as Vanguard founder Jack Bogle explains, is to have “confidence in the mathematics” of long-term, buy-and-hold growth.

Rough years for hedge funds

According to Hedge Fund Research, their HFRX equity hedge index was down 1.57% year-to-date as of 14 September 2015, compared with -3.72% for the S&P500 index (so far, so good). But for 2014, the hedge fund index was up 1.42%, versus 13.69% for the S&P500 (including dividends); corresponding figures were 11.14% versus 32.39% in 2013, and 4.81% versus 16.00% in 2012. Another index, the Barclay Hedge Fund Index was down -2.39% as of the end of August 2015; up 2.88% in 2014; up 11.12% in 2013; up 8.25% in 2012, and -5.48% in 2011, again trailing the S&P500 index for each of the years 2011-2014.

Over a five year period ending 30 April 2015, the HFRX equity hedge fund index has yielded an annualized return of 4.83%; the S&P500 has returned 14.31% — nearly three times as much. In general, very few, if any hedge funds can beat, over the long-haul, the simple strategy of buy-and-hold the S&P500 index (or other broad-market index); its 10-year annualized return (as of 31 December 2014) is 7.67% and its 20-year annualized return is 9.85%.

Perhaps it is not entirely fair to compare hedge funds to the S&P500 index, since many of these funds hedge against volatility. But as Simon Lack points out, hedge funds have failed to out-perform a 60%-40% stock-bond index portfolio for every year since 2002, both in nominal and also in risk-adjusted terms.

Along this line, about six years ago famed investor Warren Buffett wagered the manager of a New York hedge fund that money invested in a S&P500 exchange-traded index fund would beat the hedge fund over a ten-year test period. Six years into the bet, it appears that Buffett will win handily.

Hedge fund closures

According to a Bloomberg report, 461 hedge funds closed just in the first half of 2014 alone. Agecroft Partners expects more U.S. hedge funds to close in 2015 than in any year since the 2008-2009 financial crisis. Commodity-based hedge funds have been hit particularly hard.

The situation is not much better in Europe. Worldwide, 40% of hedge funds that closed in 2014 were in Europe. In the second half of 2014, investors withdrew USD$13 billion more than they invested in European hedge funds.

Do hedge funds provide an effective hedge?

As mentioned above, hedge funds are typically targeted to very wealthy individuals, but between 50% to 70% of hedge fund money comes from institutions.

So why wouldn’t large institutional investors invest in hedge funds? After all, individual investors may be attracted to a fund with a “hedged” strategy to soften market downdrafts in shorter time horizons. But as Roger Lowenstein points out, institutions such as large university retirement systems live essentially forever, and thus should not be so concerned about hedging against short-term volatility. Perhaps for this reason, recently the California Public Employees Retirement System (CALPERS) announced that it will end its investments in hedge funds. On the other hand, the California State Teachers’ Retirement System has announced that it might invest more in hedge funds.

In any event, is it really true that hedge funds are effective in softening market volatility? In particular, Macro funds are supposed to specialize in volatile environments such as the one experienced in recent weeks (August-September 2015). As Sheelah Kolhatkar and James Stewart point out, some of the most prominent funds did rather poorly in August. The Greenlight Capital flagship fund fell 5.3%; Third Point dropped by 5.2%; Ray Dalio’s macro fund declined 6.9%; and Pershing Square Capital Management dropped 9%. These figures are not much different than the S&P500 index, which dropped 6.3%. A 60%-40% stock-bond index portfolio dropped only 3.6%.

Another sticky issue is the salaries of hedge fund managers. In the sixth straight year of mediocre performance, the managers of the 25 largest hedge funds earned, on average, approximately USD$500 million each.

Can markets be predicted?

In a previous blog, we pointed out that these results should not come as a surprise. After all, markets by definition incorporate the collective judgments of many thousands of highly trained market analysts worldwide, who employ sophisticated mathematical algorithms running on powerful supercomputers to ferret out any regularities or correlations, and then use high-frequency trading algorithms to act on these phenomena. These efforts largely cancel each other out, leaving a time series that is little more than a random walk. It could be argued that some pockets of opportunity existed in the 1980s and 1990s, when computer technologies were scarce and as a result some agents were more informed than others. But in today’s world, those informational asymmetries are largely gone, and so are most of the “easy” opportunities.

Of course, some hedge funds appear to deliver outstanding performance over time. But this may be the effect of survivorship and selection bias, rather than management skill. So let’s not be surprised that even the most sophisticated hedge funds have difficulty achieving consistently above-market returns. After all, they are betting against (almost entirely) random noise.

Comments are closed.