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People like to compare. I guess it is just human nature. But many times, the basis for comparison may not make a lot of sense. If you are a fund manager, you might encounter people that frequently compare your fund against the stock markets regardless of what the fund strategy is. For example, I will not be surprised if an investment manager who runs a dedicated short bias fund receive questions like "Why did your fund not make any money? This is one of the best bull markets in history!" or a long-only manager getting quizzed on why he failed to deliver a positive return during a huge market crash. On the positive side, more often than not, this stems from a lack of understanding of the product's strategy rather than being unreasonable.
In this piece of writing, I am also doing a comparison. I will be pitting hedge funds against the global equity markets. I will admit it is not really comparing apple to apple. But you could see them in news every now and then anyway. Hedge fund performance has, in particular, come under close scrutiny after the subprime meltdown in 2008. Why? Because equity markets have steadily risen, especially US, after rounds and rounds of global quantitative easing flushed the system with cheap money. Hedge funds as a group, on the contrary, lagged far behind during this period. Index fund proponents and hedge fund critics, including renowned investor Warren Buffett, were quick to lambast the industry's poor performance, high fees, and question its value.
But have hedge funds really lost its shine? Let's look further.
Who Are The Participants?
Let me first introduce our participants in this little study:
1. HFRI Fund Weighted Composite (HFRI FWI) - A USD-denominated index net of expenses and fees, comprising of 1500 equal weighted hedge funds (excluding Funds of Hedge Funds), each of which has at least USD 50 million assets under management (AUM) and 12 months track record.
2. HFRI Fund of Funds Composite (HFRI FOF) - A USD-denominated index net of expenses and fees, comprising fund of hedge funds i.e. fund that invests in multiple hedge fund managers for diversification. Criteria for inclusion into the index is similar to the HFRI FWI. This index should be less susceptible to certain biases that plague the HFRI FWI, but, of course, there are other tradeoffs which I will touch on later.
3. HFRI Equity Hedge (HFRI EHI)- A USD-denominated index net of expenses and fees, comprising equity long-short funds. Criteria for inclusion into the index is similar to HFRI FWI. This index is probably the most similar to MSCI World, asset class-wise, as it derives its returns from equities.
4. MSCI World (MSCI WL) - A market cap weighted index that captures large and mid-cap companies in 23 developed markets. I am using the USD denominated value of the net index i.e. the index includes dividends less taxes. Note that this is a passive equity index and hence no expenses or fees are involved.
The data used are of monthly resolution as HFRI only provides monthly data.
Important Things To Note
I have said this earlier. This is not going to be an apple to apple comparison. But as with many instances in life, unlike a highly controlled science experiment you did back in school, you can never establish perfect comparisons. You will just have to make do with what you have, but at the same time, be cognizant of existing issues that may skew the findings.
Here are some points to take note of:
1. Hedge fund indices suffer from numerous biases such as selection and survivorship bias. It is not mandatory for a hedge fund to report performance to any index providers. Thus, managers can opt to start reporting only when they have good performance. This is a form of selection bias. Fortunately, HFRI does not backfill the data of the new manager into its index. It only starts including it henceforth, meaning only future performance of the manager is taken into account.
Funds that have shuttered mostly due to performance reasons may also stop reporting to the index provider way before the fund even close, omitting a period of bad performance which would otherwise drag the index down. This leaves only surviving funds, which tend to be the good performers, thereby putting an upward bias on the index performance. This is called survivorship bias. However, aside from poor performance, there are also funds that did very well, but cease reporting because they are no longer taking in money. So, while the former produces an upward bias, the latter creates a downward bias which reduces this effect.
To mitigate some of these biases, I included the HFRI fund of funds index. All managers managed by the fund of funds will be accounted for in the returns submitted to the index provider regardless of whether their performance is good or bad. Individual managers would not have the choice to opt out of reporting in this scenario. They are left out only when they are no longer invested by the fund of funds. But, of course, one can argue that there is active selection by the fund of funds to pick good managers and drop bad ones as well. The representation may also be less comprehensive as fund of funds has a tendency to go for more established managers. To top it off, they charged an additional layer of fees complicating matters.
2. HFRI indices are equal weighted. The index is rebalanced annually and equal weight is applied to all funds. That inherently suggest an active mechanism where winners are sold and losers are bought to maintain the weights. One can also contest that the results can be skewed upwards as emerging managers, which receive the same weightage as established managers, tend to deliver higher returns in the long term.
3. HFRI indices have no equivalent investable products. There are investable products such as ETFs and index funds that are replicated after MSCI WL. HFRI indices, however, have no such investable equivalents. Its underlying funds are investable though. But it will take an enormous resource to allocate capital to 1500 hedge funds. It is, at this moment, an index used mostly for benchmarking and tracking broad hedge fund performance.
4. HFRI FWI and HFRI FOF are not pure equity indices. HFRI FWI and FOF cuts across many asset classes, geographical regions, strategies, and time frames. MSCI WL, on the contrary, is a pure equity index. That is why I included HFRI EHI, the equity hedged (long-short) index for hedge funds, in our comparison.
5. Volatility is used as the risk measure here. Despite its prevalent use and being adopted in modern portfolio theory by Harry Markowitz, volatility as a proxy for risk has been controversial. Because it does not measure how much you can lose (in a more permanent sense) based on exposure to some specific factors. Technically, it is nothing more than just an indication of how much the value of a security or fund can move from an expected average, both upwards and downwards over time.
Advocators see it as the shortfall risk you may experience should you need to liquidate at an inopportune time. Others will contest that an investor with a long-term horizon would render this reasoning less compelling. And the list goes on. But I am not here to debate this. Yes, everyone has a point. Volatility is not perfect. It is indeed not a good proxy for many types of risks e.g. tail risks, counterparty risks, fraud risks, liquidity risks etc. But at present, we have no means to adequately quantify some of these risks, much less to unify them into a single sensible statistic. And if we are talking about large diversified portfolios, as is the case in this exercise, then some of these risks may be dramatically reduced. And to show a slightly better picture, I have also included other metrics like maximum drawdown into this exercise.
Round One - Bull and Bear Let's Compare
Much of the flak directed at hedge funds in recent years arose from their relatively poor performance after 2008. Since the worst of the subprime crisis in early 2009, we have witnessed one of the longest bull markets marked by record low volatility in history, thanks to the central banks for their relentless money printing. This led to a sharp contrast in performance, casting a bad light on hedge funds. But to be fair, we should look further back in history and cover more market cycles instead of just cherry picking post-2008 period for comparison.
I have taken data as far back as 1990. This is the earliest for HFRI indices. But it should suffice as we have 3 bear and 3 bull phases to examine over this period of approximately 29 years. I define any bear market here to be a drop of more than 20% on the MSCI WL. Let's have a look at the returns and the maximum drawdowns generated by the indices over each bull and bear period. For the chart, I have presented it in log scale, else we would not be able to see the different curves clearly in the earlier years.
1. Almost all HFRI indices underperform MSCI WL during bull markets, except during the rise of the internet in the 90s. In terms of trend, it would seem that the disparity is getting wider with each bull market. The worst for hedge funds is post-2008. One reason is persistent low volatility, particularly since 2013. Quantitative easing fueled excess liquidity and stock market optimism, propping up asset prices. During this period, you hardly see any major surge in volatility. A few notable ones are Brexit in 2016 and the more recent collapse of the XIV ETF in February 2018. These blow-ups, while spectacular, are short-lived. Hedge funds pursue a wide spectrum of strategies, some of which are uncorrelated to the general market but depended on a certain level of market volatility to thrive. Many hedge funds also had in place short positions, whether as a hedge to guard against market sell-offs or for profit purposes. Over the long run, these impose a drag on their overall performance during market rallies.
2. All HFRI indices outperform the MSCI WL during bear markets and by no small margins. This strongly suggests we should not discount hedge funds yet. It is worth noting that during the Kuwait invasion (Jan 1990 - Sep 1990), hedge funds actually made quite a fair bit of money, and during Dot Com Collapse (Apr. 2000 - Sept. 2002), they lost no more than 10%. This is in sharp contrast with MSCI WL which lost 24.3% and 46.8% respectively in the same periods. Even during the latest subprime meltdown (Nov. 2007 - Feb. 2009), hedge funds managed with about half (or less) of what MSCI WL loses. These are significant outperformance during critical times.
3. All HFRI indices consistently experienced a lower drawdown in all the periods, regardless of whether market is in a bull or bear phase. In fact, the drawdowns are much lower in most of the periods. This means an investor in hedge funds will lose much less, historically speaking, even if he has chosen the worst possible time to invest and redeem.
Round Two - Let's Look Longer Term
So how about longer-term performance? Let's see how the HFRI indices stack up against the MSCI WL.
1. Annualized returns - In terms of annualized returns, HFRI FWI and EHI still holds the upper hand against MSCI WL if we take results since 1990 and 2000. HFRI FOF, however, underperformed here. If you noticed, the FOF seems to trail both MSCI WL and its 2 other brethren. I did not dive deep enough to explore this phenomenon. Manager selection skills can play a part, though I would think a larger portion of this underperformance may be attributed to an additional layer of fees. MSCI WL, on the other hand, clearly held the lead in the period since 2009.
2. Total Returns - For the periods since 1990, HFRI FWI and EHI deliver more than twice and almost 4 times the total returns of MSCI WL respectively. Let's rebased the indices to start at $1 from Jan 1990. If you had held a dollar worth of HFRI EHI, it would be worth more than $21 today, and a dollar of HFRI FWI would be $14. HFRI FOF and MSCI WL look more comparable, at about $6 each today.
3. Annualized Volatility - In terms of annualized volatility, all HFRI indices are significantly less volatile than MSCI WL. Volatility is a common proxy for risk. It gives an indication of how much we can deviate from the expected returns.
4. Sharpe Ratio - It is never complete to look only at returns or risk in isolation. A good fund would be able to give you more bang for the buck in terms of more returns per unit risk taken. Sharpe Ratio measures this. For simplicity, we will just take the returns and divide by volatility to get their respective Sharpe Ratios. After adjusting for volatility, all HFRI indices deliver more returns per unit volatility over all the periods considered, even for the period since 2009.
5. Excess Returns over MSCI WL - A key contention is that hedge funds performance has deteriorated over time. It would indeed appear so from the data thus far. To get a more precise picture, I computed the excess return of each HFRI index over MSCI WL each month. Then I build an equity curve for each based on their monthly excess returns. You can see that the HFRI excess returns fall during bull market periods and then it catches up rapidly during bear markets. But since 2009, these excess returns have been falling steadily for a protracted period. While HFRI FWI and HFRI EHI remains above water, FOF has dipped into negative territory i.e. below MSCI WL. It is, however, still premature to decide conclusively how this will unfold in the future.
6. Other metrics - Let's take a look at some other metrics computed for the period since 1990. HFRI indices all experienced significantly less drawdowns than MSCI WL. Their average monthly upside is also more than the downside, with their best and worst month giving comparable returns. Overall, this is a desirable outcome. MSCI WL, on the other hand, has a less favorable performance here.
Warren Buffett's Decade-Long Bet (Dec. 2007 - Dec. 2017)
I thought of sharing my views on this famous bet. Warren Buffett has always been a hedge fund critic. In Dec. 2007, he placed a million-dollar bet that an index fund would outperform hedge funds over the next 10 years. And he won. For the same period, MSCI WL delivered a total return of 63.4% beating all 3 HFRI indices. But that is only if you look at absolute returns. On a risk-adjusted basis, using Sharpe Ratios, hedge funds still have a slight lead. Moreover, if he had picked a longer period or any other 10-year cycle that exclude post-2008 period, the results might have been radically different. Still, I have to give him the credit of choosing right time to make the wager. A win is a win. In the meantime, we can wait and see how things turn up in another 10 years.
Parting Thoughts - Hedge Funds Still Has An Edge
The results look quite clear. Hedge funds still have the edge over the long term.
Even though hedge funds may appear to have deteriorated after 2008, I would say this is not out of expectations. Hedge funds tend to underperform the stock market during bull phases. And this has been an exceptionally long bull market. If the current bull market continues raging on without signs of abating, I would expect hedge funds as a group to lag even further behind, and any buffers that hedge funds have accumulated since 1990 could possibly be eroded away.
To many, it seems like a no-brainer to make money. All one has to do is to buy a low-cost index fund or ETF and hold it. Why bother investing in hedge funds and pay costly fees to someone who can't even beat the market? But all parties will come to an end, and we should not forget that hedge funds have delivered significant outperformance during all the previous downturns. I believe hedge funds still have a place as an attractive alternative investment.
Until then, let's see if the buffer runs out before the bear comes.
Disclaimer: Any views or opinions represented in are personal and belong solely to me. It does not represent any other people, institutions or organizations that may or may not be associated with in professional or personal capacity. The views or opinions are not intended to offend or malign any religion, ethnic group, club, organization, country, company or individuals. The content is provided for informational purposes only. It is not intended to be, nor shall it be construed, as an offer, or a solicitation of an offer, to buy or sell an interest in any fund or security. I make no representations as to accuracy, reliability, completeness, suitability or validity of any information.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.