For the first time since 2009, the average hedge fund outperformed the S&P 500. Many enthusiasts within the space thus heralded 2018 as a turnaround year. At the same time, news stories focused on the implosions of well-known hedge fund managers. In my view, neither perception is accurate. It's important to step away from the immediacy of individual successes and failures in favor of longer-term composite data.
About two years ago, I argued that aggregated measures of hedge fund performance substantially lagged basic investment strategies. See The Case For Hedge Funds is Evaporating. Part of the argument rested on an inherent bias in the compilation of hedge fund returns. The participation of any hedge fund manager is voluntary. That tends to skew reported results in a positive direction.
Major hedge fund databases do their best to reduce reporting bias among their contributors. For example, most prohibit attempts by new entrants to backfill performance with positive results. Some biases remain stubborn, however.
Hedge funds are subject to a lot of churn. The high rate of turnover creates special problems for performance aggregators.
- Over 15% of the hedge funds that were reporting performance to the Lipper Hedge Fund database stopped submitting their results during the Great Recession.
- In 2018, one of the "best" years for hedge fund performance, about 1,300 closures occurred. That's about 19% of the nearly 7,000 funds tracked by hedge fund data provider BarclayHedge.
When there is high turnover in a statistical sample, it is reasonable to expect two things. Failing hedge funds are not attaching priority to reporting their results to third-party databases. Secondly, those missing results are not very good.
Are there measures of performance that are less subject to bias? Perhaps. There is a cohort of investment products within the hedge fund universe known as Funds of Funds (FOFs). The FOF manager selects and maintains a portfolio of the "best" hedge funds to meet the needs of the investor. In theory, the FOF operator can swap in new hedge funds when others fall out of favor. Thus, the FOF should offer more consistent performance reporting in turbulent times.
Let's take a look at longer-term data, reviewing the performance of various hedge fund aggregates against a simple passive benchmark. The hedge fund industry is fairly new and has grown rapidly since the millennium. It's a nearly $3 trillion business now that is not comparable to the niche marketplace that operated in the 1990s.
Results from three reputable hedge fund databases are presented below: Hedge Fund Research (HFRI), BarclayHedge, and Eurekahedge. Hedge fund composite returns are compared against a simple portfolio of two investable securities. The largest ETF (SPY) is used to represent the S&P 500 and Vanguard's Total Bond Index (VBTLX) serves as a fixed income benchmark. The weighting is 60% stocks and 40% bonds.
One might quibble with the selection of investable benchmarks. Yet, I feel they are pretty close to the mark. Both are well-known aggregates that represent the majority of American public markets. If nothing else, the data utilized has been very consistent. We've been using similar time frame and performance aggregates for the past five years.
Let's first compare the performance of Funds of Funds to the US consumer price index (CPI). This is a pretty low bar, but one which most of the indices clear. The chart below narrates the progress of $10,000 invested in each of the three Funds of Funds indices against the CPI. For the record, the annual rate of inflation over this period was 2.04%, and FOF performance ranged from 2.04% to 2.98%. Not a big difference but ... better than nothing.
To widen our perspective, we consider the performance of the 60/40 passive benchmark over the same time frame. One picture is worth a thousand words.
It's important to note that the greatest recession in our lifetimes occurred right in the middle of this time series. Shouldn't that present an opportunity for the world's smartest financial minds running hedge funds? A prescient money manager could sidestep the 2008-09 debacle and jump on the reflationary bandwagon that followed. Yet the data disputes this hypothesis. The 60/40 portfolio returned 6.68% annually over the same sample period.
Let's put aside the Funds of Funds aggregates for a moment and attribute their poor performance to a massive laying of management expenses. There are still composites of individual hedge funds that we can measure. The chart below compares HFRI's composite hedge fund index against the same passive benchmark. Despite the voluntary reporting mechanism, the hedge fund composite seriously lags the S&P 500 and aggregate bond index.
The hedge fund industry is fairly new within the context of world financial markets. Its existence rests on the belief that superior investment skill can be identified by outside investors and exploited to advantage. Yet the results to date suggest that the industry subtracts from its investors.
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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.