The Case For Hedge Funds Is Evaporating

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Hedge funds have delivered poor risk-adjusted returns in the last ten years.

Hedge fund performance is overstated as a result of voluntary reporting.

It is not feasible to identify good hedge fund managers in advance.

A recent article in the Financial Analysts Journal (FAJ) argued that, despite recent setbacks, hedge funds offer diversification benefits to the investor. Its author based the conclusion on performance measures obtained from hedge fund indices. I differ with his methods and offer an alternative view.

The FAJ Editor's Corner starts off in the right direction by trying to assess performance of hedge funds on a risk­-adjusted basis. The article points out that the Sharpe Ratio of aggregated hedge fund indices has been superior to the S&P 500 since January 2009.

In my view, the Editor's Corner methodology was flawed for a couple of important reasons. It merely compared hedge fund performance to the S&P 500, hardly a comprehensive measure of investable assets. And, secondly, hedge fund indices themselves suffer from a significant self­-reporting bias that inflates the returns driving Sharpe ratios.

Hedge funds theoretically have access to a wide range of financial products. Large cap US stocks such as those found in the S&P 500 are merely a fraction of their opportunity set. One would expect that managers deliver better and better performance (certainly not worse) as their range of options expands.

With that in mind, I expanded the investable benchmark to include bonds. Nothing fancy --­ just used a balanced portfolio comprised of 60% of the S&P 500 and 40% of an aggregate bond index. The aggregate bond index is hardly a niche index intended to inflate benchmark returns. It includes about 80% of the US public debt market. This benchmark was a true investable portfolio as it was constructed from actual returns of a Spyder ETF (NYSEARCA:SPY) and Vanguard's Total Bond Index (MUTF:VBTLX).

Two time frames were considered. The period cited by the FAJ author spanned January 2009 to the present. We used that, and also reviewed the trailing ten years back to November 2006. The latter time frame provides insight over a more diverse set of economic conditions.

The Editor's Corner piece indicates that hedge fund composites produced Sharpe ratios that were more than 30% higher than the S&P 500 benchmark. As the tables above reveal, a small expansion of the benchmark opportunity set to include bonds changed the results. The balanced 60/40 portfolio produced a better Sharpe ratio over both periods examined.

How reliable are those hedge fund index returns anyway? Unlike mutual funds, hedge funds report voluntarily. The hedge fund industry has a high churn rate, as the Editor's Corner itself notes:

The global financial crisis (January 2008 to May 2009) was a difficult time for many hedge funds. A little over 15% of US dollar denominated hedge funds ceased reporting their results to the TASS database.

Hedge fund managers do not keep superior performance to themselves in the midst of a financial market collapse. A reasonable person would infer this missing return data contains sub-par performance.

Academic researchers have more formally investigated the bias inherent in the voluntary nature of hedge fund reporting. For example, Aiken, Clifford, and Ellis found that the first unreported quarter performance of funds that de-list from databases is over 1.5% less than the last reported quarter. It's not the databases' fault -- they can't force managers to report bad news.

The story doesn't stop there. A hedge fund index and a passively managed portfolio are not really comparable. Anyone can invest in the 60/40 passive portfolio used as the benchmark. They can just submit a couple of trade orders with their broker.

However, there is no way to invest in a "weighted composite index" of hedge funds. Editor's Corner correctly points out that the volatility of a single hedge fund is higher than a composite of many funds. Aggregating hedge fund data offsets some idiosyncratic risk. A real world investor buying a single fund can expect to capture the return of the aggregate but will likely suffer greater volatility than expected.

The Editor's Corner remedy for this statistical drag is to utilize funds of funds (FOFs) -- recommending positions in at least ten funds to capture the benefits of diversification within the space. The instinct may be right but the execution is thwarted by the high costs inherent in the FOF structure.

The FOF has a general manager who serves a permanent "consultant" to the hedge fund portfolio. This general manager, for a generous fee of about 1.2%, will rotate the best individual hedge fund managers into the FOF portfolio to deliver the best results. The fee of the FOF manager is layered on top of the fixed and performance-based expenses of the underlying hedge funds.

FOF expenses impose a big drag on returns. Nevertheless, their aggregated performance could serve as a proving ground for the strategy that Editor's Corner advocates. The good news is that both HFRI and another quality vendor, Barclayhedge, have been producing composites of FOF performance.

We can use this data to obtain a track record of the FOF strategy. The performance of the two FOF indices is evaluated against the passive 60/40 portfolio and the CPI in the two tables below.

It's not a big surprise. The extra layer of fees takes its toll in the long run. The house always wins. The investors are the losers. The Sharpe ratio of the balanced portfolio is significantly higher than either FOF composite. There are several useful takeaways from the data above. The FOFs are, as a group, less volatile than individual hedge funds. They deliver some diversification. However, it comes at a high cost. The FOF composites have average returns more than 1.0% lower than the HFRI aggregate of individual hedge funds.

I included the CPI inflation rate as an additional measure of comparison. Over the past ten years, FOFs haven't even delivered returns to match the hurdle of historically low inflation. That should concern a prospective investor.

Certainly the Great Recession depressed hedge fund returns along with other asset classes. But hedge funds should be able to draw the best opportunities from stocks and bonds. Stocks and bonds have done fine. A balanced portfolio of stocks and bonds outpaced inflation by 4.3% annually over the last ten years, amidst a devastating recession!

The hedge fund universe has expanded dramatically since the 1990s. What was once a niche industry has ballooned to manage over $2.8 trillion. In my view, there are too many managers chasing too few investment ideas to generate real value.

Even insiders are losing faith. 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. I wouldn't jump into a boat that is taking on water.

Disclosure: I am/we are long SPY, AGG.

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

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