Hedge funds are able to charge large fees based on the premise that their unique skills allow them to generate risk-adjusted outperformance (alpha) after expenses. Apparently investors believe the premise as interest in hedge funds has exploded over the past 15 years. One subset of hedge funds is commodity trading advisors (CTAS). As an indication of their popularity, it's estimated that at year end 2012, CTAs managed nearly $330 billion, an increase of more than 500 percent in just five years.
Authors, Geetesh Bhardwaj, Gary B. Gorton, and K. Geert Rouwenhorst, of the paper "Fooling Some of the People All of the Time: The Inefficient Performance and Persistence of Commodity Trading Advisors," studied the performance of CTAs. They found that between 1994 and 2012, the average bias-adjusted CTA returns after fees was 1.8 percent above the return on U.S. Treasury bills, an amount that was statistically indistinguishable from zero. Interestingly, they noted that this finding confirmed the findings of a prior study on CTAs done over two decades ago. They also noted that the results of that study were widely reported in the media. Obviously, neither their poor performance, nor the publicity about their poor performance, hindered the ability of CTAs to generate assets. In fact, just the opposite occurred as investors have dramatically increased their allocations to CTAs following decades of poor performance.
The authors did find that the gross (before fee) returns of CTAs were a statistically significant 4.3 percent a year higher than the net returns. In other words, fund sponsors captured most of their performance through charging high fees. The average fixed fee was 1.9 percent and the variable fee averaged 17.3 percent. They also found that even before fees, CTAs displayed no alpha relative to simple futures strategies that are in the public domain - a survey found that about three-quarters of CTAs are trend followers and are momentum traders.
Their evidence led the authors to conclude: "CTAs appear to persist as an asset class despite their poor performance." They hypothesized that this persists because "investors' experience of poor performance is not common knowledge."
In search of an explanation for this phenomenon, the authors tested to see if there was the well-known "lottery ticket" effect at work - investors have a preference for assets that exhibit excess kurtosis (fat tails) and positive skewness (the returns to the right of [more than] the mean are fewer but farther from the mean than the values to the left of the mean, like a lottery ticket). They found, however, that while CTAs do exhibit large skewness, they are just as likely to have performance that is negatively skewed (which investors hate) as positively skewed. Thus, they rejected the lottery ticket explanation.
They next looked at how CTAs performed in a portfolio context, specifically looking for a diversification benefit - how CTAs perform when stocks did poorly. If that was the case, it could explain the investments. They found that "CTAs do well in the months when the S&P500 is doing very poorly and conversely do poorly when the S&P500 is doing very well." While this provides evidence of a diversification benefit which could justify investment, they noted that the same diversification benefit could be obtained far more cheaply using passively managed indices of commodities futures. Thus, there's no justification for using CTAs to obtain that benefit.
The findings of this paper on CTAs is consistent with the findings on the research on hedge funds in general - hedge funds have no special abilities to generate alpha (excess returns). Yet, they have been successful for decades now in transferring money from the wallets of investors to their wallets - confirming what P.T. Barnum supposedly said: "You can fool some of the people all of the time."