Why Hedge Funds Are Overstated

by: Toro

Are hedge fund returns overstated? Yes, yes they are.

It's difficult finding a comprehensive and clean database of hedge fund returns. What studies that have been done have shown that hedge funds return about the same as the market, only with slightly less volatility. And when I stop being lazy, I'll link a study or two making this conclusion.

On Wednesday, Dealbreaker delved into the murky world of hedge fund returns.

Dutch Economist Henry Kat, profiled in a recent was skeptical that hedge funds produce alpha after 2 and 20 (or much higher for the average fund of funds (3 and 30) or funds run by a secret cabal of international quants and a chain smoker), which doesn’t make us feel that bad for thinking the same. ...

Kat followed through on his hedge fund skepticism by conducting two hedge fund related studies. The first, published in the June 2003 Journal of Financial and Quantitative Analysis, looked at the fee-adjusted returns of 77 funds from 1990-2000 in relation to returns generated by market benchmarks with similar risk profiles. The result – 72 of 77 funds failed to outperform the benchmark.

The second, posted online as a working paper in 2006, looked at more than 1,900 funds and generated a similar result. Only 18% of funds beat the designated benchmark, and the most successful funds had declining returns over time. The after-fee alpha was negative in the vast majority of cases.

How do hedge funds convince rich investors otherwise? For starters, they exaggerate, demonstrated in a 2005 paper by Malkiel and Saha (a Princeton Prof and a N.Y. investment analyst). The study showed that funds are usually telling fish tales when talking about past performance and that hedge fund returns in aggregate are skewed by the mysterious disappearance of imploded funds from databases. Factoring dead or missing funds into the picture, Malkiel and Saha found that hedge funds made an average return of 9.32% from 1996-2003, instead of the 13.74% average return of funds in published databases. Another study (Brown, Goetzman and Liang) suggested that fund of fund fees negate what is generated in above market returns.

This is the New Yorker article that was referred to in the above article.

When Kat examined the databases, he noticed that in most years hedge funds outperformed the Dow and the S. & P. 500; they appeared to have produced alpha. But the figures in the databases don’t take into account the unusual risks that hedge funds take. Many funds use borrowed money to leverage their investments; they short stocks; and they speculate on the price of volatile commodities, such as gold and coffee. ...

In a study published in the June, 2003, issue of the Journal of Financial and Quantitative Analysis, he and a co-author, Gaurav Amin, an analyst at Schroder Investment Management, a British financial firm, compared the fee-adjusted returns of seventy-seven hedge funds between 1990 and 2000 with the returns generated by a market benchmark that had a similar risk profile. Seventy-two of the funds—more than ninety per cent—failed to outperform their benchmarks.

With the help of a graduate student, Helder Palaro, Kat also undertook a larger study, in which he examined more than nineteen hundred funds. The results, which Kat and Palaro posted online as a working paper last year, showed that only eighteen per cent of the funds outperformed their benchmarks, and returns even at the most successful funds tended to decline over time. “Our research has shown that in at least eighty per cent of cases the after-fee alpha for hedge funds is negative,” Kat told me. “They are charging more than they are adding. I’m not saying they don’t have skill; I’m just saying they don’t have enough skill to make up for two and twenty.”

Other economists had been scrutinizing hedge funds closely. In a widely discussed 2005 paper, Burton Malkiel, a Princeton professor, and Atanu Saha, a New York investment analyst, argued that many published estimates of hedge-fund returns are misleading. Malkiel and Saha discovered that funds tend to exaggerate how well they performed in the past, and that those which perform badly often close and disappear from databases, leaving a biased sample. After examining results of now defunct firms, Malkiel and Saha found that between 1996 and 2003 hedge funds made an average return of 9.32 per cent, significantly less than the 13.74-per-cent average return of funds included in the published databases.

Stephen Brown, William Goetzmann, and Bing Liang, researchers at New York University, Yale, and the University of Massachusetts at Amherst, respectively, have published data suggesting that the fees paid by investors in many funds of funds negate most or all of what is generated in extra returns. And several groups of researchers—including William Fung, of the London Business School, and David Hsieh, of Duke; and Jasmina Hasanhodzic and Andrew Lo, of M.I.T.—have shown that broad market movements in the prices of stocks, bonds, and other common securities account for a good deal of the variation in hedge-fund returns. These findings suggest that stock picking, trading smarts, and computer algorithms are less important than many scholars had thought. “Our idea was to see how much of the variation in hedge-fund returns you could explain using very simple, passive investment strategies,” Lo said. “Given all the hype and mystique surrounding hedge funds, we expected the answer to be ‘very little.’ We were quite surprised to find that it was about forty per cent.”