Hedge fund performance – how good is it really?

According to research commissioned by KPMG and the Alternative Investment Management Association hedge funds were the top performing asset class from 1994 to 2011. The study by the Centre for Hedge Fund Research at London’s Imperial College found that hedge funds outperformed traditional asset classes such as equities, bonds and commodities, and did so with considerably lower risk volatility than stocks or fixed income investments. 

 

The report “The Value of the Hedge Fund Industry to Investors, Markets and the Broader Economy” noted that per annum hedge funds returned 9.07 per cent on average after fees between 1994 and 2011, compared to 7.18 per cent for global stocks, 6.25 per cent for global bonds and 7.27 per cent for global commodities. At the same time the volatility and risk measures of hedge funds as an asset class during the period were closer to those of bonds, which are normally considered the least risky and volatile. 

“This research is powerful proof of hedge funds’ ability to generate stronger returns than equities, bonds and commodities and with lower volatility and risk than equities,” commented Andrew Baker, AIMA’s CEO.  

The report also concludes that portfolios including hedge funds outperformed those with more traditional asset allocations. A portfolio which included hedge funds outperformed a conventional portfolio that invested 60 per cent in stocks and 40 per cent in bonds, according to the study and also yielded a significantly higher Sharpe ratio, which characterises how well the return of an asset compensates the investor for the risk taken. At the same time it had lower “tail risk”, in other words a lower risk of extreme volatility. 

“The report is good news for the hedge funds industry in the Cayman Islands as it disproves common public misconceptions that hedge funds are expensive and do not deliver. The strong performance statistics, showcased in our study, speak for themselves,” said Anthony Cowell, partner, Alternative Investments at KPMG and co author of the report. 

These results are however at odds with the views expressed by hedge fund critics such as Simon Lang, who in his book The Hedge Fund Mirage comes to a strikingly different conclusion. 

One of Lack’s arguments is that while the performance of hedge funds has been strong initially in the 1990s, the industry itself was very small. In 1997 assets under management had reached only $118 billion compared to $2 trillion today. The majority of capital invested in hedge fund investors has been invested for less than ten years and during that time the performance was not as strong. 

The report’s statistics bear this out too. If the 18 year period from 1994 to 2011 is divided in three six year periods, the average annual aggregated return generated by hedge funds was 15.04 per cent until 1999, 7.43 per cent between 2000 and 2005 and only 4.22 per cent from 2006 until 2011. The last two periods included of course the dotcom bubble and the financial crisis of 2008, which in part explain the poorer performance.  

The study’s reported hedge fund return of 9.07 per cent over the 18 year period therefore shows how the average fund performed, but not the return that the average investor received. In order to determine the average return for the investor it would be necessary to look at asset weighted returns, giving more weighting to returns when more money was invested, rather than time weighted returns, by taking annual returns and averaging them. 

Lack blames the size of the industry for the performance by arguing that it simply becomes more difficult for hedge funds as an asset class to generate the returns of the 90s. Similar to individual hedge funds which on average generate the highest returns when they are small and focus on steady but still attractive returns later, Lack asserts the principle applies to the industry in general. 

Self-selection bias is another problem with hedge fund indices. Hedge fund managers can start and stop reporting when they want.  

In particular poor performing hedge funds will have little incentive to publish their return if they don’t have to. The report turns the argument on its head, stating that “hedge funds with superior performance may not choose to publish their returns, due to the fact that they already reached their target size or they prefer not to reveal their returns to their competitors”. Both effects would largely cancel each other out in practice and the self-selection bias is negligible, the report claims. 

 

Correlation benefits 

Irrespective of the validity of this argument the main conclusion of the report remains that “hedge funds provide significant diversification benefits, since they have low correlations with conventional asset classes over business cycles”.  

The average correlation between hedge funds and global stocks is quite high (0.8), while hedge funds exhibit a negative correlation of – 0.06 with global bonds and a positive correlation of 0.41 with commodities. The correlations between an average hedge fund and main asset classes vary over time given that hedge fund investment strategies are dynamic, moving between asset classes and instruments. While the correlation to stocks has been constantly high, correlation to bonds and commodities was volatile. Since 2007, however, the rolling 12 month correlation between the average hedge funds and commodities has been nearly as high as the correlation to stocks, the reports data showed. 

The report also finds that the vast majority of a hedge fund’s returns are generated by alpha, ie the skill of the manager. 76 per cent of the average hedge fund’s performance is due to alpha and only 24 per cent is the result of market movements, or beta, which suggests that hedge funds add value on top of funds that track aggregate returns of conventional asset classes. 

“Overall we find that hedge funds are able to deliver economically important abnormal performance, on average, across strategies, and even during the recessions,” the report said. 

The important question for hedge fund investments is whether this excess performance is tied to excessive risk. The study finds that measured by volatility and Value-at-Risk this is not the case.  

“Indeed, we document that hedge fund volatility is reasonably low across investment strategies compared to conventional asset classes. The only exception is the risk level for global bonds, which have a lower risk than hedge funds. However, global bonds deliver significantly lower returns and Sharpe ratios, suggesting that hedge funds’ risk-taking is compensated by higher average return,” the study concludes. 

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