Tough times for hedge funds

The past few years have not been kind to hedge funds, namely those specialized funds, usually marketed to large institutions and wealthy individuals, which combine a somewhat more risky overall strategy managed by highly professional traders, with a relatively safer “hedge” to limit volatility. (Our comments here refer specifically to investment hedge funds, as opposed to, for example, an airline hedging future fuel prices or an international corporation hedging future currency rates.) Worldwide, hedge funds currently manage USD$2.86 trillion in assets, down from USD$3.2 trillion in September 2015.

Hedge funds typically charge a management fee of 2 percent plus a performance fee (fraction on profits) of 20 percent. Some hedge funds, such as one managed by quant guru Peter Muller, charge a 3 percent management fee and a performance fee that can rise to 50 percent.

Recent hedge fund performance

2015 was a rocky year for hedge funds, with an overall loss of 0.85 percent in the HFRI Fund Weighted Composite Index, compared with a 1.36 percent gain for the S&P500 index. The list of hedge fund managers whose fund lost money for the year includes such respected names as William A. Ackman, Larry Robbins, Leon G. Cooperman, Daniel S. Loeb, David Einhorn and Jeffrey W. Ubben. Some, such as Larry Robins and William Ackman suffered double-digit losses.

So far 2016 is not any better. The HFRI FWCI index declined 0.67 percent in the first quarter, as compared with a 0.77 percent rise in the S&P500 index.

What about a longer-term horizon? This table compares the Barclay Hedge Fund Index with the S&P500 index over the past five years:

Year BHFI S&P500
2016 (YTD) -0.81% 0.77%
2015 0.04% 1.36%
2014 2.88% 13.52%
2013 11.12% 32.15%
2012 8.25% 15.89%
2011 -5.48% 2.10%

Note that the Barclay index has an average 3.36% annual gain for 2011-2015, versus 12.58% for the S&P500. Needless to say, this is a substantial shortfall.

The situation is not much better in Europe. The Eurekahedge European hedge fund index rose just 0.7% in 2014, much below gains in North America and continuing eight straight years of underperformance of benchmarks.

Hedge fund closures and institutional exits

Not surprisingly, numerous hedge funds have closed. Some of the larger hedge funds closed in 2015 are the Fortress Macro Fund, Bain Capital’s Absolute Return Fund, JAT Capital, Everest Capital and the Renaissance Institutional Futures Fund.

In addition, several large institutional investors have recently announced that they plan to liquidate their hedge fund holdings. In September 2014, the California Public Employees’ Retirement System announced that it plans to liquidate its entire USD$4 billion investment with hedge funds, saying that they are too expensive for the performance achieved. Similarly, in April 2016 the New York City pension fund announced that it will liquidate its USD$1.5 billion hedge fund portfolio.

Are broad-market index funds too volatile?

Obviously, hedge fund investors do have alternatives, notably to simply invest their money in a low-cost index fund and then, as Vanguard’s Jack Bogle recommends, “Shut your eyes and let indexes do the work.” In response, some have argued that a full-bore equity index strategy exposes the investor to excessive risk. One writer argued that since the U.S. stock market declined more than 80% during the Great Depression of 1929 and took 23 years to recover, for example, a hedged strategy is essential to avoids repeats of such losses.

However, it is hard to square this oft-repeated claim with the facts. According to market analyst Mark Hulbert, only seven years elapsed between the 1929 market high and the break-even point in 1936, and only four and one-half years elapsed between the 1932 market low and its full recovery in 1936. Part of the confusion is that the 23 year figure typically cited does not correctly account for other factors, including deflation and dividends, as well as the distinction between the overall market and the Dow Jones Industrial Average.

Some observers still insist that a residual fraction, roughly 10% to 15%, of hedge fund managers consistently demonstrate above-market results. But how do we identify those hedge fund managers? And even if, say, 10% to 15% have a good record, why is that not merely a 10-15% statistical fluke?

In any event, is it really true that hedge funds are effective in softening market volatility? In particular, Macro hedge funds are supposed to specialize in volatile environments such as the one experienced in August-September 2015. However, as Sheelah Kolhatkar and James Stewart point out, some of the most prominent funds did rather poorly in August 2015. 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%.

Can markets be predicted?

As we have argued in previous blogs, these results should not come as a surprise, since 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 is hard to bet against random noise and make money!

[Added 27 Apr 2016:] Some additional data and discussion has been published in a Bloomberg article. It notes that according to Hedge Fund Research, 979 funds closed in 2015, the most since the financial crisis of 2009.

[Added 1 May 2016:] Warren Buffett, quoted in a Bloomberg report, says that “salesmanship” has masked poor returns in high-fee funds for years, and that they “underperform what you could get ‘sitting on your rear end’ in index funds.” This same Bloomberg report includes the latest results from a bet that Buffett made in 2007, namely that a Vanguard S&P 500 index fund would out-perform a basket of hedge funds from 2008 through 2017. Eight years into the bet, the hedge fund portfolio is up 21.9%; but the S&P 500 index fund is up 65.7%.

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