Are The Wheels Coming Off The Hedge Fund Bandwagon?

Includes: SPY, VBTLX
by: Louis Kokernak, CFA


Hedge funds' results are poor and getting worse.

Recent fund of fund performance has lagged inflation over the last 10 years.

Widespread redemption and political scrutiny threaten the industry.

Hedge funds are in the headlines again. Recent developments have shined an unwelcome light on these rather opaque investment vehicles. Reported results for the first quarter were consistently negative for hedge funds, while conventional asset classes, such as US stocks and bonds, delivered positive returns.

This prompted industry insiders and outsiders alike to question the bloat in the industry. Dan Loeb, founder of money manager Third Point LLC, opined that hedge funds are in the "early innings" of a washout after delivering "catastrophic" performance results. Warren Buffett took aim at the consulting industry, which often recommends hedge funds to those investing large amounts of capital.

"Supposedly sophisticated people, generally richer people, hire consultants. And no consultant in the world is going to tell you, 'Just buy an S&P index fund and sit for the next 50 years,'" Buffett said. "You don't get to be a consultant that way, and you certainly don't get an annual fee that way."

There is statistical evidence of the difficulties facing hedge funds. The last two quarters have seen substantial withdrawals from the industry. Over $40 billion in net redemptions have occurred during that time.

Such withdrawals are not without precedent. However, they are now occurring in the context of a lengthening history of poor investment performance. Moreover, hedge funds are in the political crosshairs of presidential candidates for the favorable tax treatment they receive.

Let's focus on the investment returns of the hedge fund universe. Because the reporting of hedge fund results is voluntary, there is an inherent positive bias in the construction of indexed returns. Hedge fund managers tend to stop reporting if their strategies implode. Unlike mutual funds, we only get to see the ones that remain viable.

There is a way to minimize the selection bias, and that is by restricting our examination to the results of funds of hedge funds (FOFs). The FOF has a general manager who serves a permanent "consultant" to the hedge fund portfolio. The idea is that this general manager, for a generous fee, will rotate the best individual hedge fund managers into the FOF portfolio to deliver the best results. As long as they survive, the FOFs report performance through the churn of the individual managers. Relying on FOF data alone should reduce (not eliminate) statistical bias in reported results. Roughly one-sixth of hedge fund assets are subsumed in FOFs.

One might argue that part of the problem with the hedge fund industry is that it has become too bloated. In 1997, hedge funds controlled barely more than $100 billion in assets under management. Today, most tallies of the hedge fund industry place it at close to $2.7 trillion. Coincidentally, its performance gap increases with assets under management.

In an earlier article, I compared hedge fund returns unfavorably to those of core assets such as US stocks and bonds. Let's update the narrative to 2016 and lower the performance bar by using the rate of inflation (Consumer Price Index, or CPI) as a benchmark.

Both BarclayHedge and Hedge Fund Research assemble fund of funds' performance results and compile aggregated monthly returns in the space. They do a decent job of teasing out some of the biases inherent in voluntary reporting.

Funds of funds have performed poorly, in the aggregate, over the last ten years. In fact, both the BarclayHedge and Hedge Fund Research FOF composites lagged inflation over that period! That should concern anyone considering an investment in a vehicle that typically charges 2% of assets plus 20% of profits. The chart below describes a $10,000 investment in the two hedge fund indices against the CPI.

Ten years is not that long of a time from the standpoint of statistical inference. Hedge fund managers might just be in a slump. But keep in mind that hedge fund managers play in the same sandbox as stocks and bonds. Both of those asset classes substantially outperformed inflation during that same ten-year period, which included the greatest recession of the last 80 years.

Both asset classes did well. $10,000 invested in the popular S&P 500 fund (NYSEARCA:SPY) would have generated over $19,400 with reinvested dividends. The Vanguard Total Bond Market Index Fund (MUTF:VBTLX) would have increased to over $16,000 after ten years.

We've had a lot of volatility in the past ten years. One would think that kind of investment environment would invite skilled managers to shine. Hedge fund managers, as a group, have not measured up.

Somewhere, hidden in the roster of 11,000 hedge funds, there may be some stock-picking talent. However, the space has become crowded with mediocrity. Maybe there is too much money sloshing around in hedge funds to implement effective trading strategies. Skilled managers... who knows, there just isn't an easy way to find them. As a group, their value is not evident. Perhaps there is just too much hedge fund money chasing the same well-worn strategies. The industry may need to be cut down to size.

Disclosure: I am/we are long SPY VBTLX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.