More Doubts About Hedge Fund Performance

Hedge funds charge vastly higher fees than other money managers because they allegedly deliver better investment returns. Yet when you look at most hedge fund indices, they don’t look much better, and are sometimes worse than simple long-only strategies. And remember these indices almost certainly overstate performance, since they exhibit what is called “survivorship bias.” Funds that die are not included in the index, and since the mortality rate among hedge funds is higher than among mutual funds, it produces a greater gap between the returns reported in the indices versus those earned by a typical investor.

There are other distortions in results shown by hedge fund indices: the hedge funds report voluntarily, and they tend not to report poor results; the figures they submit are not audited; the results can include the best results from funds being incubated with small amounts of money.

The result of these distortions in aggregate is significant. A 2003 study, “A Critical Look at the Case for Hedge Funds,” by Richard M. Ennis and Michael D. Sebastian published in the Journal for Portfolio Management, found that from 1992-2002, the Hedge Fund Research Composite Index’s reported an average return of 11.3%. Yet the Hedge Fund Research Fund of Funds Index, which gives the results earned by investors in funds of hedge funds, showed returns over the same period of only 7.1%. And remember funds of hedge funds are supposed to allocate capital to the winners. This return also fell short of the performance of S&P 500 Index and the Lehman Aggregate Bond Index over this time frame.

Yet one rationale for hedge funds still persists: some hedge funds produce superior returns repeatedly. Unlike mutual funds, where mean reversion rules out, various studies have found that some top performers remain top performers.

Even that defense of hedge funds may have bitten the dust. A new study claims that the earlier research was based on faulty methodology.

Remember the logic for the exorbitant hedge fund fees. Investors are paying for “alpha,” that is, the excess return (meaning the return in excess of the “market” return). Investors are willing to pay for alpha because it is considered to reflect an investment manager’s skill, and managers who can regularly outperform the market are rare indeed.

The new paper, “Hedge Funds: Ability Persistence and Style Bias,” by Matteo Belleri and Marco Navone (hat tip All About Alpha) tells us that the past research on this topic is largely bunk:

…the vast majority of the relevant contributions is focused on the persistence of funds total return. Only a small number of articles try to analyze the persistence of fund managers ability measured as the difference between fund return and the performance of an index of hedge funds with the same strategy.

The authors found something sneaky: while a few managers did outperform repeatedly in their reported strategy, when they reran the numbers, defining the strategy based on a three year regression of returns, they found no persistence in superior performance.

What does this result suggest? Style drift. Hedge fund managers are supposed to adhere to a certain program, say global macro, market neutral, distressed investing, emerging markets, commodities. What the authors’ findings suggests is that hedge fund managers cheat. If their strategy is going cold, they dabble in something else.

Now if you an old-fashioned hedge fund investor, meaning a wealthy individual, you’d applaud someone who behaved like that. All you care about is absolute, or perhaps inflation-adjusted, return.

But institutional investors have become the dominant force in the industry, and they care not only about the alpha a fund generates, but also its “alternative beta.” The fact that a particular hedge fund does global macro means it has a profile of returns that may not be correlated with other investments the fund has, and is attractive for that reason. Thus, if a fund deviates from its style, it won’t deliver the type of alternative beta it promised. That is a major no-no for the hedge fund consultants who serve as the gatekeepers for institutional investors.

The study by Belleri and Navone is a major challenge to conventional wisdom about hedge funds. It will be interesting to see what sort of additional research it provokes.