July 12, 2013

Stop Investing In Hedge Funds Now! Oh No, Wait A Minute...

“Don't Invest in Hedge Funds” is probably the refrain you have been hearing and reading over and over again recently. The so-called “smart money” has been under attack as it has failed to beat the market and deliver juicy returns. Some hedge fund managers were harshly criticized because of their attacks on the FED and the monetary policies it has executed in recent years. While the reasons for their hatred towards Bernanke could originate from their trading positions (as Brad DeLong explained in this post) we should bear in mind that one size does not fit all. Blaming the hedge fund category as a whole is not only wrong, but silly. First of all, accurately quantifying the returns of hedge funds is very hard, if not impossible. For the simple reason that, the large majority of them do not disclose their performances to the public. Matthew O’Brien, in his latest piece for the Atlantic, used a performance chart looking over only ten years and the HFRX index as if this is an index of hedge funds (like the S&P 500 for stocks for example). But that’s wrong. The HFRX shows the return of an index that attempts to track broad hedge-fund performances through the most diffused hedge fund strategies. Several indices which track hedge funds strategies have been constructed to try to replicate their performances. But this is not an easy task! With a lot of limitations. Robert Frey (Professor at Stony Brook University) and myself, find the EDHEC index much more representative than the HFRX. The EDHEC index takes into account the high fees (1% fixed fee of all assets, 10% of all profits), which have been heavily criticized. This finds Matthew and myself in agreement. If we take a look at the cumulative return over the 2000-2013 time window we can see that:
Chart 1 - Courtesy of Robert Frey

And if we enlarge a little bit the time horizon, here is how the hedge fund performances look like:
Chart 2 - KPMG, AIMA, Centre for Hedge Funds Research

It seems like hedge funds have performed pretty well over a longer period of time. The two charts emphasize the big losses hedge funds incurred during the financial crisis. From Chart 1, we can also see that hedge funds have recently struggled a little bit to generate "abnormal" returns against the S&P 500. One could say “but it does not tell me anything about the risk taken by the industry, performances are not risk-adjusted” and this is of course a reasonable objection. However, it is almost impossible to measure the risk-adjusted returns of hedge funds because any measure of risk-adjusted returns is hocus pocus. Hedge funds have quantitative and qualitative risks that make them unique to evaluate and analyze. Someone else could say “An equally split (50%-50%) stock/bond hedge fund would have done better than the 60%-40% stock/bond portfolio”. Reasonable too. Objections can be many! But let's focus for a moment on the recent performances. Hedge funds lost a lot of money during the crisis and let's admit that they haven't been able to beat the market recently. Are those good excuses not to invest in hedge funds? In my opinion no, and here is why. 
We are missing three very important points here:
1. Hedge Funds provide diversification. Investment strategies of hedge funds vary vastly. To list a few: directional strategies, market-neutral strategies, equity long/short strategies, event driven funds, macro strategies, fixed income arbitrage, short bias etc. A lot of hedge funds try to achieve positive returns using strategies that move in the opposite direction of the major market indices. They therefore suit perfectly for diversification purposes. Risk, the premier journal for risk managers, found that 10 to 15 hedge funds are needed for optimum portfolio diversification: 

2. Hedge funds can improve an investor's overall return. It’s pretty common to think of hedge funds as risky bets. But hedge funds can be used for several purposes. There are in fact, low-volatility hedge funds that can enhance returns at limited costs. Or alternatively, returns can be boosted by using hedge funds that particularly focus on high-return strategies by trading volatile products. Generally speaking, investors look at hedge funds as dynamic and flexible investment vehicles able to be traded under several market circumstances. And when implemented in a portfolio with proper due diligence and awareness of the risks involved, benefits may be several. 

KPMG, AIMA, Centre for Hedge Funds Research

3. Continued interest in hedge funds has never diminished, regardless of the recent negative performances and the adverse articles on the media. The asset under management stands at around $2.375 trillion. Compared to the $100,000 first investment in the first hedge fund under Alfred Winslow Jones in 1949, that should equate to a 30.39% annualized growth rate in AUM. If hedge funds have had such a high growth rate, it would indicate much better performance over time (see Chart 2), especially given the fact that they haven't been able to, historically speaking, advertise. Prequin data shows that 60% of institutional investors, primary source of capital for hedge funds stated in 2013 that they are looking to increase their hedge fund allocation. And this should not be surprising, given the current macroeconomic environment and how hysterically investors have looked for yield in the last year or so. Investors, in fact, are getting prepared for both growth and volatility and use hedge funds as a way to access "dynamic and interconnected markets and to mitigate the risk inherent in these exposures". Like in point 2, the flexibility of these instruments is something that investors demand.

One big problem for the industry as whole, now that some hedge funds will be able to advertise themselves, may be the pollution coming from people who are largely incompetent, crooks, or whoever does not use the most up-to-date financial tools. An investor should be able to pick the good hedge funds. Investing in hedge funds because something is called "hedge fund" should be strongly avoided. And this is easier said than done.  An investor carries together with the trade its own risk attitude as well as its own grade of financial sophistication, with a trade-off between the two. 
Dreaming double figures returns is easy. Finding ways to systematically trade is harder
Taking Matthew O'Brien's paradox to the extreme, what’s worse? Rich people blowing money in hedge funds that are highly inaccessible to retail investors or the same retail investors being harmed by mutual funds that take fees from them but don’t deliver alpha?



  1. Great post! It's important to note that hedge funds overall have proven to be less, not more, volatile than the equity market. The problem with comparing a low volatility investment with a high volatility one over too short a time period is that the greater volatility of the latter creates intervals of dramatic over- and under-performance over the former.If we limit ourselves to, say, five year periods then we can selectively demonstrate that hedge funds are tremendously better (or worse) than equities depending upon the interval. The true picture emerges only when we look over a long enough time period.

  2. n investor should be able to pick the good hedge funds. Investing in hedge funds because something is called "hedge fund" should be strongly avoided.

    Yep, this is what I see as the crux of the problem for anyone choosing a third-party money manager of any kind...

  3. The main problem I see with this is, for the period of outperformance, hedge funds were an esoteric vehicle, and only the true superstars were in a position to start one. The hedge fund world today is crowded and totally difference.

    The other issue is, how investable is the EDHEC index. There are some highly successful large hedge funds that are not open to new investors. And finding the newer hedge funds which have a good shot at success is hard, unless you're the Yale endowment or someone like that who gets an early look and has the skills to pick them. Funds that are successful long-term tend to have their best performance in early years, when they are small and nimble and the manager is hungry, and if they remain successful are hard to get into in later years.

    1. It doesn't matter much whether the EDHEC index is "investable" or not. Find me an Hedge Funds index that is truly representative of the hedge funds world as a category...I guess it's almost impossible to find one...
      Hedge Funds will exist until inflow of $ > outflow of $, that is, until investors will keep seeing the "value proposition" in them.

  4. Thank goodness Humans are excellent at picking investment managers like Mutual funds or hedge funds !

    Oh, wait . . .

    1. You are right. But I did emphasize that point in my post. :-)

  5. One quibble: Why use 1 & 10 for the fees on this index? The average is undoubtedly closer to 2 & 20 for the universe of hedge funds. And my understanding is that the HFRI self-reported returns are net of fees. I think that makes you understate that impact. Beyond that, I'm not too familiar with the EDHEC indexes, but they seem intriguing and I will look into them further.

    Secondly, why do you say any measure of hedge funds risk-adjusted returns is hocus pocus? Perhaps from the outside looking in that might be the case, but if you are in the position to invest in hedge funds, from most funds you absolutely get sufficient information to make a determination about an appropriate risk-adjusted benchmark. Granted some strategies it is difficult/impossible (CTAs and macro strategies tend to be more blackbox type strategies, so one could make a very valid argument as to why even invest in something you don't/can't understand and can't get any sense of what to expect going forward), but we can focus on equity L/S, where it's really not that difficult at all--especially in assessing past performance.

    Say i'm evaluating a L/S equity hedge fund that focuses on US equities(and let's say it's all cap but more of a bias towards mid and large) and has historically had a net exposure that ranges between 40-60%. As a risk-adjusted benchmark I could reasonably use a 50/50 blend of Russell 3000 and either cash or BarCap Agg. If the strategy has comparable volatility and drawdown stats to that index, but its performance has lagged over say the past 5 or 7 years I could fairly comfortably say that this strategy has not added any value, right? Or conversely, how could you look at that comparison and then justify that strategy over a highly liquid and investable benchmark?

    Either way, these are just my naive thoughts. I do manager research for a firm that allocates client capital via third party managers. We do actually use hedge funds, however we tend to be biased towards fundamentally-focused funds, and few meet our criteria as we continue to find that most simply do not add value over time on a risk adjusted basis and many actually fail to provide any correlation benefit beyond their blended benchmark.

    1. Well, you are missing something very important. By assessing the risk from the perspective of its volatility, you are assuming that they are one and the same. The only role of volatility is to give an intelligent investor the opportunity to make intelligent buy and sell decisions from a value orientation. In this case, volatility should be welcomed in a portfolio. In general, the problem with assuming that volatility is risk and vice versa is that you make the assumption that markets are efficient, which is far removed from reality. In actuality, you can only assess true risk by conducting a thorough fundamental analysis of the positions in a portfolio and determining whether or not those risks are likely to result in a permanent loss of capital on an inflation-adjusted basis (though this can result in subjective measures of risk but that should be able to be kept in check by adopting a large margin of safety). The reason that the article states that attempts to measure risk for funds is hocus pocus is due to the fact that it is virtually impossible to determine the risk of permanent loss for all of a fund's investments, unless you have inside knowledge of all of their holdings and decisions and analyze each investment individually.

  6. Can anyone shine some light on the EDHEC hedge fund index?

    Mostly I am fascinated why you would account for fees as 1 & 10 and not 2 & 20.

    1. You can find the answer to your question here:

  7. 1) The increase in AUMs can simply be a principal agent problem, and indeed, given your graph, it appears that much more of the money invested is not coming from someone that benefits directly. It is increasingly coming from middle-(wo)men.

    2) Why are you using EDHEC index? Looking at the description, it appears to be a couture index that maximizes Sharpe ratio (which itself has variables that can be measured by different means). I don't understand how creating an index that has done well in past is valuable. Fancy index picking is no different than stock picking... pretty sure Fama wrote on that topic.

    3) Many studies that have investigated the returns of hedge funds have shown they have been awash for a while. Most promoted returns suffered from bias - selection, non-dollar weighted, etc. David Swensen has written about the many games funds use in order to increase their public numbers. When those games are factored out - e.g. it is hard to pick funds that will do well in the future - then you don't see much in terms of returns.

    1. 1) Regardless, people still see the "value proposition" and invest in hedge funds as (inflow of $ > outflow of $). Also, look at the other side of the coin, institutional investors have recently become the most important source of capital for hedge funds.

      2) I use the EDHEC index because, contrary to the other hedge funds indices, EDHEC does take into consideration fees (the other ones simply do not). Plus it's more representative than any other one as it is a meta-index. It's almost impossible to find an hedge fund index that is truly representative of the hedge funds as a category.

      3)I disagree with you. There are excellent studies out there that actually contradict your theory. See for example: