Executive summary
Hedge Funds use trading strategies that aim to profit from market imperfections
The general idea is that Hedge Funds are managed by smart traders that focus on highly specialised strategies to make profits from market imperfections in ways that are largely unrelated to broad market moves. The traders then take 20% or more of those profits in fees before passing the balance back to investors. All good when profits are plentiful.
Twenty years of plenty followed by twenty years of drought
Hedge Funds have been around in various forms since the 80âs and we have good data on returns since the late 80âs. For the first two decades of their life they produced outstanding returns on average, 6% to 8% per annum above cash. For the past twenty years – not so good. Around 2% to 3% per annum above cash.
Too much money chasing limited opportunities at too high fees
After decades of great performance in the 1980âs and 1990âs, money poured into Hedge Funds – between 1998 and 2008 total funds under management soared twenty fold. Unfortunately, the market imperfections upon which these funds rely did not increase at the same rate and so, with each extra dollar invested, it became harder and harder to make profits. The high managersâ fees, which were justified when profits were substantial, now just eat into investor returns.
Not much of a hedge, except for Trend FollowersÂ
Prior to 2003 Hedge Fund ups and downs were largely independent of equity markets – they provided real diversification. Around 2003, that all changed. The ups and downs of Hedge Funds on average started to mirror the market – poor returns from equities coincided with poor returns from Hedge Funds. The diversification benefits disappeared. Nonetheless, there is a sub-class of Hedge Funds, Trend Followers, which do appear to provide genuine diversification for equity investors.
Where are the customersâ yachts?
A study published in 2014 analysed performance of Hedge Funds from both the perspective of the investor and the fund managers and concluded that Hedge Funds have been one of the all time great wealth creation vehicles – for fund managers. The study estimated that, between 1998 and 2013, of the US$596 billion in pre-fee profits, just $30 billion went to investors with the remaining US$566 billion being paid as fees.
Be skeptical, careful and patient
There may be a place for Hedge Funds in portfolios – if the returns are uncorrelated with equities and if you donât expect your managersâ stellar past returns to repeat regularly.
Spotlight on Hedge Funds
What are Hedge Funds anyway?
For the purpose of this SPOTLIGHT, Hedge Funds are essentially funds managed by specialist traders that exploit opportunities in markets arising from inefficiencies identified by those managers.
Amongst Hedge Funds there is an enormous array of very different strategies that, at first glance, cannot be lumped together. However, from our perspective, all the different Hedge Fund strategies, including equities trading, commodity trading, trend following and various forms of arbitrage, are a little like the hundreds of stocks that make up an equities index. All those stocks are fundamentally different from one another but when they are brought together they, as a group, become more predictable. Particularly as these funds are often accessed by a Fund of Funds where experts combine the best managers and diversify the risks associated with any one strategy.
Hedge Fund fees are normally a variant on the 2 and 20 principle: a 2% per annum base fee plus 20% of all profits made. This is steep but certainly worth it if the strategies consistently deliver good returns. But do they?
Twenty years of plenty followed by twenty years of drought
To assess if Hedge Funds consistently deliver good returns we look at Hedge Fund of Fund returns as measured by the HRF Fund of Fund Index. A Hedge Fund of Funds is a predominantly market neutral fund where the manager brings together a number of different strategies trying to diversify away all the different factors and risks until we are just left with the cash rate plus the managersâ value add – which we will refer to as Alpha in this paper. To assess past returns we look at performance of Fund of Funds rather than an index of individual funds for a few reasons;
- Indices that look at individual funds often suffer from survivor bias. Only the funds that start well get to be included in the index and those that fail often simply stop reporting returns. In contrast, a Fund of Funds reports the results of all the funds they actually invest in and, better still, fully include the impact of fund failures.
- Fund of Funds are run by managers who spend all day every day studying the market for new talent, allocating capital to only the best managers and prudently divesting those funds which have gone into decline. The returns of Fund of Funds should be better than those available from allocating capital equally to all managers.
- Fund of Fund returns probably reflect the best that a diligent part-timer could achieve by carefully selecting a diversified portfolio of Hedge Funds.
Figure 1, below shows how Alpha (Fund of Fund returns less cash returns) has varied over time. Note that this chart uses ten year rolling periods hence the first data point on the chart (7.4% per annum in 1999) refers to the returns above the cash rate achieved by these funds on average over the 10-year period from 1989 to 1999.
That excellent outcome proved to be unsustainable and gradually wound down over time but still averaged around 5% per annum during the halcyon days of Hedge Funds from the late 80âs to the 2007 (the shaded section of Figure 1)
After 1998 (that is, the decade ending in 2008 in the chart above) it all became much more difficult; returns were generally just 1% to 2% per annum better than cash – not much better than investing in Term Deposits.
The indifferent results of Hedge Fund of Funds over the past two decades tells us that past performance is not a good guide to future performance in the Hedge Fund world. If it was, the Fund of Fund managers would simply give all their capital to the managers with good past returns who would then replicate those returns in the future. Clearly, this does not happen.
Figure 1 also begs the question: what changed between 1999 and 2008?
Too much money chasing limited opportunities – and too high fees
The main change was caused by the huge inflows into this type of investment, mainly from institutional investors, who found the offer of higher than equity returns at much lower risk to be utterly irresistible.
Returning to our definition of Hedge Funds as being trading strategies designed to capture anomalies in markets – if the amount of anomalies in markets does not grow as fast as the funds being managed, then the amount of profit for each dollar invested must fall.
This is because the Hedge Fund managers are trying to outsmart other market participants and so they can only gain if someone else loses. Unfortunately, the amount of losses the market can fund are limited.
Figure 2 illustrates the huge growth in Hedge Funds under management since 1988 in two different ways. In the blue bars we see the total Funds Under Management which has grown rapidly despite a period of outflows post-GFC due to the unexpectedly poor returns of Hedge Funds during that time. Secondly, to put the raw numbers in context, the orange line estimates how the size of the Hedge Fund industry has grown compared to the growth in opportunities for managers to create Alpha.
The orange line shows Hedge Funds Under Management as a percentage of the market capitalization of the US stock market. While there are obviously many profit opportunities available outside of US equities, if we assume that those opportunities grow at about the same rate as equities, then the ratio represented by the orange line is meaningful. What it clearly shows is that the growth in Hedge Funds between 2000 and 2008 was many times the growth in opportunities to make money for investors and so it should not surprise us that the returns from these funds fell sharply as new money flooded in.
The other feature hurting Hedge Fundsâ returns is the very high fee structure which exacerbates the problem of too much money chasing too few opportunities.
As funds poured in, pre-fee returns fell as the available profit for each dollar invested fell. Unfortunately for investors, the fees did not fall as fast as returns which meant that fees took an ever increasing slice of the shrinking pie; less for the managers but much less for investors.
Too much money chasing limited opportunities – and at too high fees.
Where are the customers yachts?
In 2014, Simon Lack, a former manager of Hedge Fund of Funds with J. P. Morgan published an analysis of the Hedge Fund industry entitled âThe Hedge Fund Mirage.â In this analysis he estimated that between 1998 and 2012 the Hedge Fund industry generated US$590 billion of profits from their investment activities of which US$560 billion was paid as fees to the managers leaving just $30 billion for investors.
He described the Hedge Fund industry as one of the worldâs greatest ever wealth creation vehicles – but only if you were Hedge Fund manager.
In fairness, while the analysis was probably pretty close to the mark for the period under review, a similar analysis for the period from 2012 to 2022 would have probably showed something like $2,500 billion total profits divided evenly between the managers and the investors.
Even so, how is it that a 2% and 20% fee structure results in half the profits going to the fund managers?
Itâs just the way the math works. Consider an investor with two Hedge Funds, one makes 30% before fees while the other loses 10%. Figure 3 shows how that reasonable looking result reduces a pre-fee return of +10% on average to a return of +5% after fees. That half of the performance goes to the fund manager is largely because the successful manager gets to keep their performance fee while the less successful manager doesnât refund a portion of the losses they have generated.
The marketers go to work
In practice, what happens next is that the managers who have produced the poor returns quietly close up shop or start a new fund. The successful managers redouble their marketing efforts based on their stellar past returns. New money comes in from investors hoping that the past is a great guide to the future. Regrettably, as we learned earlier, past returns are not much of a guide to future Hedge Fund returns.
What are the lessons here? Firstly, diversification is important as the range of returns from these funds is wide. However, because of the nature of the fee structure, where winners keep their performance fees but losers do not refund a share of losses, diversification reduces returns as well as risk.
Secondly, because winners remain in the market and losers close up shop, there will always be a substantial number of managers who are able to boast stellar returns, for a while at least. Unfortunately, past returns are a poor guide to the future.
Not much of a hedge
The term Hedge Fund is often thought to mean that these funds hedge against negative moves in other markets; that they are a great diversifier. In fact, the term Hedge Fund refers to the underlying strategy of many Hedge Funds which is to buy an asset that looks cheap and sell a very similar asset that looks expensive. The net result should be that, as the prices of both assets converge to fair value, we make a profit while taking very little market risk. That is, the underlying market risk is hedged away by the two similar but offsetting positions.
The reality is somewhat different. Figure 3 shows the rolling one year returns of Hedge Fund of Funds compared to one year returns of US equities as measured by the S&P500.
The shaded region shows that prior to 2003 Hedge Funds did behave quite differently to equities and were a useful diversifier. That all changed in 2003. Since that time the Hedge Funds and equities have moved in lockstep.
Clearly the Hedge Funds began to take on substantial exposure to equity-like risks. This suggests that, far from being market neutral, Hedge Funds have around 30% to 35% exposure to equity risk. That they donât fall as far in downturns is because they are less than 100% invested in equities – not because they have magical defensive properties.
The bottom line is Hedge Funds in general are not much of a hedge, and are, in fact a poor portfolio diversifier.
Trend Followers do hedge but only for the patient
There is a sub-class of Hedge Funds that do offer the prospect of genuine diversification. These are Trend Followers (often described as CTAs because their managers are loosely described as Commodity Trading Advisers.) The managers use sophisticated formulas to buy assets that have been increasing in price and hold them until they begin to fall.
As we see in Figure 4, for reasons that are unclear to farrellyâs, they do appear to zig when equities zag and so do offer the prospect of genuine diversification for equities investors. (To highlight this relationship we use different scales for each in Figure 4)
However, patience will be required. As we see in Figure 5, in most years these funds produce returns below cash with the occasional burst of high returns. Between 2005 and 2018, these funds produced returns below cash in 10 out of 14 years. That is the price of being uncorrelated to equities – in most years equities do well and these Trend Followers struggle.
What is more difficult to assess is what long-term return these funds are likely to produce going ahead. The Hedge Fund Index data suggests that, on average, these funds have historically produced long-term returns around 2% per annum above cash. But there are at least three reasons to be cautious about using that as a forward looking estimate of returns.
It is based on individual fundsâ returns because we have no Trend Follower Fund of Fund Index. Returns based on individual funds indices, unlike Fund of Fund indices, often suffer from survivor bias and may be overstated;
Strong inflows, which often follow periods of strong performance, can dilute future returns. We have just had three good years of returns as we see in Figure 5;
We have to choose one or two individual funds and the past performance of those funds may prove to be unrepresentative of Trend Followers in general. In fact, the reason they are on our short list is probably because they have been
uncharacteristically good compared to other Trend Followers.
Be skeptical, careful and patient
In the past the marketing of Hedge Funds has been vastly superior to the results that Hedge Funds have produced for investors. Past returns have generally proved to be a very poor indicator of future success. Be skeptical.
If using Hedge Funds as a diversifier, be careful to ensure that the funds used have long-term performance histories that suggest that they will actually rise if equity markets fall.
Finally, be patient, particularly if using Trend Followers as a diversifier. They often string together many years of poor returns before finally doing their job during an equity market downturn.
In this article we have not taken into account any particular personâs objectives, financial situation or needs. You should, before acting on this information, consider the appropriateness of this information having regard to your personal objectives, financial situation or needs. We recommend you obtain financial advice specific to your situation before making any financial investment or insurance decision.
