Hedge funds have been underperforming since the financial crisis. So why are institutional investors still allocating to the industry? Kevin Mirabile, finance professor at Fordham University, raised some of the issues the hedge fund industry is facing at the Hedge Fund Association seminar in January.
With hedge funds managing approximately $2.5 trillion to $3 trillion, exceeding the pre-crisis high by almost all measures, it is difficult to argue against the success of the industry, especially as institutional investors are pouring funds into the industry.
Pension funds and endowments have grown their share of hedge fund investments from 5 percent in 1993 to 14 percent in 1998 and to 61 percent in 2010.
Despite the record assets under management and institutionalization, the industry faces many challenges today, Mirabile said.
The original high net worth individual investor allocations have declined, as have investments by funds of funds.
“Many funds of funds find themselves struggling to explain their value proposition and to justify fees and to remain relevant to investors today,” Mirabile said.
And it’s not only funds of funds – hedge funds as a whole have underperformed in the past five years, when S&P 500 performance significantly exceeded the hedge fund industry. Even since inception, the total return from a hedge fund portfolio is now equal to the return from the S&P 500.
“Clearly many investors, if not most investors, have been disappointed by both the absolute and relative levels of hedge fund returns since 2008 and the financial crisis,” he said.
Lack of opportunities
Mirabile argued that hedge funds have struggled to deliver higher returns since the financial crisis because even the most skilled fund managers are faced with a significantly reduced opportunity set. “In fact, the headwinds that the hedge fund industry has been facing are more significant and more impactful than ever before.”
The natural edge that fund managers are paid for in terms of security selection, arbitrage and market or beta timing, is confronted with an environment devoid of opportunities.
Trying to identify mispriced government securities is difficult when the Federal Reserve is buying $85 billion of government securities each month. And the additional $2.5 trillion pumped into the fixed-income markets by the Fed make it a lot harder to make money trading fixed income.
Credit arbitrage opportunities are significantly reduced when the yields on corporate bonds are at an all-time low and the spread between corporate bonds and government securities has remained flat for 15 months.
Volatility trades, in turn, are limited as volatility has declined precipitously and consistently for a multiyear period, Mirabile said. “The only way to make money is to be short volatility, but when you are short volatility, you have unlimited losses and gains, not a prudent way to invest capital.”
Equity selection has also been hampered as index stocks increasingly tend to rise and fall together. The higher correlation of stocks with each other “makes it extraordinarily difficult to pick long positions and make investments that are designed to outperform the market” or “select short sale opportunities that are designed to do worse than the market,” Mirabile noted.
As a result, the difference between the best and worst performing hedge funds has been declining over time.
“What this really tells you is that you have more and more mediocre managers, facing a declining opportunity set, delivering similar performance.
“If funds can’t profit from security selection, arbitrage or market timing, then they are either going to do one of two things: they are going to behave like an index – and it is very expensive to pay 2 and 20 for a manager that behaves like its benchmark or its index – or they are going to take additional risk, reach for yield, increase trading and exhibit significant style drift,” Mirabile said.
Why still invest in hedge funds?
Given this is what happened since 2008, why would sophisticated, institutional investors still allocate to hedge funds at an increasing rate?
First, said Mirabile, despite the industry’s poor performance, there are still a number of exceptional hedge funds that continue to outperform, even given this smaller opportunity set, and “everyone believes they can pick a winner.”
More importantly, while the overall return in aggregate is raising many questions regarding the value proposition of hedge funds, Mirabile said, the path of hedge fund returns has been much less volatile than those of stock and bond markets.
The positive effects of lower volatility and low correlation of hedge fund strategies to equity and fixed income portfolios “really trumps the underperformance,” he said.
In other words, by allocating to hedge funds, institutional investors can lower their portfolio risk more than they give up in return. And in the best case scenario, if they pick a winner, they can achieve both lower risk and increased return.
Yet the type of return in combination with the fee structure throws up new challenges for the industry. There is no shortage of commercial and academic studies that are highlighting hedge fund performance and the high cost of hedge fund fees.
The same figures that were used to promote the hedge fund industry, comparing it to the return of a traditional portfolio mix of 60 percent stocks and 40 percent bonds, are now reversed with hedge funds performing worse, Mirabile showed.
This has put the spotlight on both fees and the composition of hedge fund returns. One academic study has highlighted that between 1995 and 2006 only 3 percent of the 12 percent hedge fund return were based on manager skill in terms of security selection, arbitrage or market timing. The remaining 9 percent were caused by general market or asset class movements (beta) and fee components and could have been achieved being long the S&P 500, Mirabile said.
Sophisticated institutional investors are becoming more sensitive to the fee structures that managers charge, with some using managed accounts for transparency and lower fees. Competitive pressures for hedge funds also emerge from retail and hedge fund replication products.
Today, many investors get hedge fund-like performance from hedge mutual funds but at a fraction of the fees. Some brand-name hedge funds and alternative investment providers have partnered with retail complexes, for example, Blackrock and Fidelity, to launch retail versions of their flagship funds.
Retail hedge fund assets now make up about $140 billion, and exchange traded funds that offer hedge fund-like strategies represent another $100 billion, or together about 10 percent of industry assets.
Hedge fund beta replication products, which generate the portion of a hedge fund’s return that comes solely from exposure to traditional asset classes and its ability to leverage or short sell, are also becoming more popular.
While this excludes any alpha, the profits generated from skill that are uncorrelated to wider market movements, Mirabile said, it is possible to capture 80 percent of the long-term return profile of a long-short equity hedge fund index at a mere fraction of the cost.
Investors are now much more sensitive to the origin of hedge fund returns and distinguish between market beta, alternative beta derived from leveraging and short selling, and pure alpha.
“In fact, investors are very willing to pay extraordinarily high fees for pure alpha, non-correlated returns unrelated to simply using leverage or short-selling but related to the ability to select stocks, execute arbitrage or time market entry and exit,” Mirabile noted.