Hedge Fund Investors – Smart Money or Easy Marks?
Hedge Funds are generally run for rich people in Geneva, Switzerland, by rich people in Greenwich, Connecticut.
– Cliff Asness, AQR Capital
In popular culture, hedge fund managers are commonly portrayed like the fictional Bobby Axelrod on the TV show Billions: daring financial pirates often engaging in ethically, or even legally, dubious behavior to enrich themselves and their fat-cat accredited investor clients. Sometimes, they are also depicted like Michael Burry in the movie The Big Short: out-of-the-box thinkers who can foresee unexpected market trends and capitalize on them. While these stereotypes might fit certain individuals, the ability of hedge funds in general to deliver impressive after-fee performance for their investors is under serious dispute.
An interesting table (see above) was recently circulating on social media and caught my attention. It shows the returns in 2021 of 38 large and reputable hedge funds, and is used to make the point that hedge fund performance last year was terrible since only 3 of these 38 funds were able to outperform the 28.71% return of the S&P 500 index. The Economist magazine has been banging the drum about the decline in the performance and popularity of hedge funds, writing a 2016 article provocatively titled Hedge Funds – Not Dead, Just Resting and another article in 2015 titled Hedge Funds – Fatal Distraction.
These critiques follow on the heels of the famous Warren Buffett bet of 2007, when he wagered $500,000 that no one would be able to pick five hedge funds that would be able to even match the returns of the S&P 500 over the next 10 years. Only one hedge fund manager, Ted Seides of Protégé Partners, took up the bet, and picked five funds-of-hedge funds, which were invested in over 100 other hedge funds, to go up against the market. In 2018, at the end of the 10-year period, Buffett announced that he had easily won the bet and would donate the winnings to charity.
When adjusted for market risk the evidence shows that, after fees and costs, hedge fund managers as a group have shown a marked decline in risk-adjusted return and appraisal ratios since the global financial crisis. -Rodney Sullivan
Of course, hedge fund managers have an easy response to these horseraces: “Why are you comparing us to the stock market? Can’t you see the word hedge in our name?” They correctly point out that since hedge funds are generally not exposed to as much risk as the stock market, they cannot be expected to match or beat the return of the market. Hedge fund managers and stock investors are competing in totally different sports, and, after all, we don’t claim that Usain Bolt is a better athlete than Michael Phelps because he has a faster 100-meter time. So what can we say about hedge funds when we make a proper “apples-to-apples” comparison?
Hedge Fund Assets
Let’s start by taking a look at the growth of the industry’s assets under management over the last couple of decades (see above). This graph shows that while industry growth is not as impressive as it was prior to the 2008 financial crisis, reports of its death are greatly exaggerated. According to data from the SEC’s Division of Investment Management, in the first quarter of 2021, there were 9,457 SEC-registered hedge funds with net assets totaling nearly $4.8 trillion. Hedge funds were offered by more than 1,700 different investment management companies.
One simple explanation is the increase in competition, with a growing number of investment managers fighting over the same-sized pie of profitable investment opportunities.
Hedge Fund Performance
Early academic studies of hedge fund performance generally found that hedge funds, on average, were able to generate positive risk-adjusted returns (or alpha). However, two recently-published papers suggest that this ability has deteriorated over time. In a 2021 paper titled Hedge Fund Alpha: Cycle or Sunset?, Rodney Sullivan notes that “when adjusted for market risk the evidence shows that, after fees and costs, hedge fund managers as a group have shown a marked decline in risk-adjusted return and appraisal ratios since the global financial crisis.” This regime shift can easily be seen in the graph above (taken from the paper), with the cumulative alpha, in blue, growing steadily until 2008 and then plateauing, and even slightly declining, since then.
A second paper published last year in the Financial Analysts Journal, titled Hedge Fund Performance: End of an Era? combines data from six different commercial hedge fund databases to get the most comprehensive view of hedge fund performance. They also find the 2008 financial crisis to be an important breakpoint between hedge fund performance superiority and mediocrity. Prior to 2008, 20% of hedge funds had statistically-significant positive returns while only 5% had statistically-significant negative returns. This flips after 2008, with only 10% having significant positive returns and 20% having significant negative returns.
The passage of the Dodd-Frank Act in 2010 led to more regulation and oversight of hedge funds. This increased the compliance costs for hedge funds, and more importantly, made it harder for them to get away with illegal activities such as insider trading or misreporting.
Why the Decline in Hedge Fund Performance?
There are a number of theories for why hedge fund performance has declined over time, and especially since 2008. One simple explanation is the increase in competition, with a growing number of investment managers fighting over the same-sized pie of profitable investment opportunities. Oversaturation initially occurred among long-only mutual fund managers when retail investors shifted from direct stock holdings to holding mutual funds. Hedge funds, which were not prohibited from using shorting, leverage, and derivatives, were able to exploit this regulatory arbitrage to generate positive alpha for longer, but eventually the money from large institutions and wealthy individuals flowed in and oversaturated that industry as well.
Another possible reason is that the post-2008 shift by the Fed to a highly accommodative monetary policy disrupted the (low) correlations that hedge funds were banking on for their strategies to work. Hedge funds typically make money by taking long positions on certain stocks, sectors, or assets classes that they expect to go up while “hedging their bets” by shorting others that are expected to go down. Research has shown that correlations are way up since 2008, indicating that financial assets are moving together like never before, thus disrupting the profitability of long-short portfolios.
Finally, the passage of the Dodd-Frank Act in 2010 led to more regulation and oversight of hedge funds. This increased the compliance costs for hedge funds, and more importantly, made it harder for them to get away with illegal activities such as insider trading or misreporting. This would also lead to a deterioration in returns.
There is one potential silver lining for hedge funds. All the studies discussed earlier that evaluate performance are based on self-reported data to commercial databases…Can we be sure that the results would stay the same if we had access to data from all hedge funds?
The second paper, discussed earlier, tests these explanations to figure out which one is most responsible for the decline in hedge fund performance. The authors summarize their conclusion as follows: “Our findings most strongly support the hypothesis that central bank intervention has affected markets in ways that have impeded the ability of hedge fund managers to sustain the performance they provided in the first half of our sample.”
Excessive Fees
One of the biggest problems for hedge fund investors is the exorbitant fees that they have to pay the investment firm. Traditionally, hedge funds have used the two-and-twenty model for fees: a 2% management fee charged as a percentage of assets under management, and a 20% incentive fee charged on fund returns above a certain hurdle rate. More recently, fees have gone down with the average hedge fund now charging a 1.4% management fee and a 16% incentive fee. Still, even these fees are exorbitant when compared to the 1% fee charged by actively-managed mutual funds or the 0.5% charged by the average index fund or passive exchange-traded fund.
Moreover, a recent working paper by Itzhak Ben-David, Justin Birru, and Andrea Rossi makes the case that due to the asymmetric nature of the incentive fee (it’s charged when a fund performs well, but there is no refund when a fund performs poorly) and the cross-sectional variation in hedge fund performance, the effective fees paid by hedge fund investors are much larger than appreciated. In fact, they calculate that 64% of all dollars generated by hedge funds (above the risk-free rate) go to pay fees, with investors receiving only 36%.
Here’s the intuition for this result. Suppose that there are only two hedge funds in the world, each with $1 million in assets, and both charge two-and-twenty in fees. In a particular year, one fund has returns of 20% while the other one has returns of -10%. The first hedge fund earns $200,000 (20% on $1 million) and pays $60,000 in fees (2% of $1 million + 20% of $200,000). The second hedge fund loses $100,000 (-10% on $1 million) and pays $20,000 in fees (2% of $1 million). Combined, the two funds earn $100,000 while paying $80,000 or 80% of the total earned dollars in fees to the manager, leaving only $20,000 or 20% of the earned dollars for fund investors. Furthermore, hedge funds strategically close down when they are performing poorly and investors tend to put more money in funds that have done well recently, which leads to even more dollars paid to managers in fees.
A Silver Lining?
There is one potential silver lining for hedge funds. All the studies discussed earlier that evaluate performance are based on self-reported data to commercial databases. However, unlike mutual funds, hedge funds are not legally required to make their returns available to the public, so all of our conclusions are based on a select sample of hedge funds that are choosing to report their returns to one or more databases. Can we be sure that the results would stay the same if we had access to data from all hedge funds?
Most of the academic literature on hedge funds thinks the answer is yes, since most fund returns are included in the commercial databases and they are broadly representative of the industry as a whole. However, a recent paper titled The Hedge Fund Industry is Bigger (and has Performed Better) Than You Think suggests otherwise. The authors obtain data from hedge fund filings to the SEC, filings which are not shared with the public, and which include all hedge funds and their returns. They use this data to study whether there is a performance difference between funds that choose to report to the public and funds that choose to keep their performance data hidden from the public.
Surprisingly, they find that the more secretive hedge funds have much higher alphas than the hedge funds that share their performance with the public. This finding goes against my prior that more successful managers would want to share news of their success to attract more clients. They conclude that “this relatively poor performance of publicly reporting funds could, in part, motivate the recent criticism of hedge fund returns by industry observers and the financial press.”
While it’s impossible for non-government researchers to replicate, or further investigate this result, it might potentially solve the mystery of why, in spite of their apparently poor performance and ultra-high fees, hedge funds continue to attract money from wealthy individual and large institutional clients.
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