Measuring the True Value Added by Hedge Funds: It May Be Worse than You Think

The co-heads of Goldman’s (GS) Global Alpha hedge fund, Messrs. Carhart and Iwanowski, are calling it quits. A few years ago I was running a hedge fund at FrontPoint Partners and we were bought out by Morgan Stanley (MS) just in time to attend MSIM’s annual managing directors meeting. All they talked about at that meeting was what MSIM could do to be more like Goldman’s Global Alpha. It was a fierce machine, the industry's gold standard. And it had some years of stellar returns. They rode their hedge fund up to a peak of $12 billion a couple of years ago. Since then they have seen it shrink to $2 billion.

If you are Carhart and Iwanowski, or for that matter AQR’s Asness or Citadel’s Griffin and have a really bad year, at least you can gain some solace by saying to yourself, “Things didn’t roll my way this year, but still, since inception I have on average delivered 15% returns.” Or putting the same sentiment differently, “Even though this has been a hard year, if you had invested $10,000 with me when I started, it would still be worth $300,00 today.”

Actually though, that's not really true. If you use those benchmarks to define your career as a hedge fund manager, you are doing it wrong. Because hardly any of your investors did put their money with you way back when. In fact, most of them put their money with you over the past three or four years, years where returns moved from hum-drum to disastrous.

I have a hypothesis that would be easy to test with the right data: Some of the large hedge funds that have drawn down substantially in the past year or two have on net lost money for their investors since inception. This, even though they have collected huge fees and have decent average annual returns. The reason I think this might be the case is that in the current downturn they had a lot more money under management, and so had more dollars to lose per unit of poor performance than when they were knocking the cover off the ball in their early years. Some of the hedge funds that are on the ropes grew larger and larger over time, reaching elephantine size just in time to implode. Some of these were already starting to stumble under their own weight in the years before that.

A performance statistic to gauge the overall economic value added by hedge funds is capital-weighted annualized returns. It would help to answer the question of a hedge fund’s – or the hedge fund industry’s – lifetime economic value added; it would be useful even for large hedge funds that have not struggled the way that Global Alpha has. Bottom line: I don’t really care as much about what a $20 billion dollar fund did ten or fifteen years ago when it had $1 billion than how it did in the more recent years when it was trying to put these larger levels of capital to work.

Comments

[athena:]

Sounds like the same problem that haunted the top mutual funds.

Apr 01 03:09 PM

[mindshar:]

Often a fund's "elephantine size" is in itself a contributor to declining returns, as quality opportunies for large risk-adjusted returns are finite, and deploying more and more capital inherently requires accepting either lower returns for the same risk or higher risk for the same returns.

Hedge funds, mutual funds, even Warren Buffett's Berkshire Hathaway share the same problem... at some point size becomes a liability.

Apr 01 03:21 PM

[Nick Gogerty:]

very true. Average or geometric weighted returns vary significantly from money flow returns in both mutual funds and hedge funds. Most investors underperform the vehicles they invest in. Buy high and sell lower is still the behavioural outcome for most allocation decisions.

Apr 06 02:04 PM

[Pau:]

'Dollar-weighted returns.' Good research/data is here:
www.mccombs.utexas.edu...
The conclusion: "dollar-weighted investor returns are about 4 percent
lower than [hedge] fund returns."

Apr 13 12:13 AM