Evaluating Hedge Funds

by: SL Advisors

By Simon Lack

Let me start by saying that I have many friends in the hedge fund industry. I’ve been investing in hedge funds since 1994. So my friends and other readers should regard what follows on hedge funds as friendly, constructive advice that will serve clients well. We all deserve better than we have received.

Hedge funds have many unique features; none is less justified than the poor transparency afforded investors about their investments. Managers of traditional strategies such as long-only public equities and fixed income and most alternatives such as private equity and real estate provide clients with timely detail on the investments made on their behalf.

But the hedge fund industry has largely succeeded in convincing its clients that they don’t need the same type of transparency provided by all their other investment managers. None of the reasons are pro-client, but they include protecting the manager’s investment process, avoiding competition for securities, strategy complexity, and simply “No”.

Conveniently, this benefits managers in that it makes evaluation of strategy and returns quite difficult, because investors don’t have the detailed information necessary to calculate how much of what risks were taken. As a result the analytical rigor with which most other investment strategies are evaluated isn’t possible with hedge funds.

While this has been good for hedge fund managers, it’s been bad for their clients. The only period in recent memory when the industry did deliver was following the collapse in the internet bubble during 2000-02. Institutional capital followed, seeking to emulate the success of some Ivy League endowments, and hedge funds’ low correlation with equity returns was the reason.

However, this low correlation is a two-edged sword, because while it makes hedge funds appear complimentary to a traditional portfolio it also makes comparing their returns with equities less relevant. Hedge funds take risks, just not the same risks as a portfolio of long equities, and since investors don’t receive transparency they were (and are) unable to evaluate those risks (other than qualitatively through discussions with managers).

The first chart below shows annual returns in % terms and annual asset growth. The second chart shows annual returns converted into profits and losses by adjusting for assets under management. The second chart is in effect the annual profit/loss for hedge fund investors.


Sources: HFRI, BarclayHedge, SL Advisors

The industry’s rapid growth led it to $2 trillion in AUM by 2008 when its lost around $500BN, more than all the profits earned since 1997 and probably in its history. Unlike mutual fund managers hedge fund managers retain complete discretion over whether to accept new investments from clients. If they feel the opportunity set doesn’t justify client capital they can “close” to new money. Many of the best managers have done this in the past, but the industry was bullish and asset growth compounded at 24% from 1997-2008.

Evaluating hedge funds based on their money-weighted performance (IRR) results in an annual return of 1.3% compared with the more commonly used average annual return of 7.5% (which doesn’t adjust for industry size). Some may dispute this method of evaluation, but hedge funds can choose to stay small if investment opportunities are limited. Since relatively few investors enjoyed the strong returns of ten years ago, the result today is that if all the money that’s been invested in hedge funds since 1997 had instead been put into treasury bills, the aggregate results for those investors would have been twice as good while also incurring far less expense and risk.

This is a quite staggering statistic. The same comparison with the Dow Jones Corporate Bond Index (an equally weighted basket of investment grade bonds) reveals that high grade bonds outperformed hedge funds by a factor of 5:1! So while hedge fund managers have created enormous personal wealth and the consultants who recommend hedge fund allocations have done pretty well, the investors in aggregate have not.

Hedge funds investments have historically been restricted to qualified investors (wealthy individuals and institutions) and based on the record the unqualified haven’t missed much.

Disclosure: No positions