By Simon Lack
Let me start by saying that I have many friends in the hedge fund industry. I’ve been investing in hedge funds since 1994. So my friends and other readers should regard what follows on hedge funds as friendly, constructive advice that will serve clients well. We all deserve better than we have received.
Hedge funds investors have long accepted far less transparency than is provided in any other strategy. Managers of traditional assets such as long-only public equities and fixed income and most alternatives such as private equity and real estate provide clients with timely detail on the investments made on their behalf.
But the hedge fund industry has largely succeeded in providing less than full transparency for a variety of reasons that aren’t all beneficial to their clients. Conveniently for hedge fund managers this has made the evaluation of strategies and returns quite difficult, because investors don’t have the detailed information necessary to calculate how much of what risks were taken. As a result the analytical rigor with which most other investment strategies are evaluated isn’t possible. Hedge funds take risks, just not the same risks as a portfolio of long equities, and since investors don’t receive transparency they were (and are) unable to evaluate those risks (other than qualitatively through discussions with managers). Who ever heard a hedge fund manager discuss tracking error or information ratio, commonly used tools in long-only strategies where positions are transparent and benchmarks are identified?
While the industry has long reported returns in time-weighted terms (i.e. the return on $1 invested at inception) a more meaningful statistic for both managers and the industry as a whole is to look at asset-weighted returns, or internal rate of return (IRR). Unlike mutual fund managers, hedge fund managers retain complete discretion over whether to accept new capital from clients. If they feel the opportunity set doesn’t justify a client’s investment they can close to new money. Since most hedge fund managers claim insight into optimal timing to invest in their strategies, it’s fair to evaluate them in a way that incorporates the timing of asset flows. After all, why not ask an absolute return manager for his profit and loss, and judge him accordingly?
However, calculating the aggregate industry IRR reveals a very different picture of performance than the traditional way of looking at annual returns. Two researchers, Ilia Dichev from Emory University and Gwen Yu from Yale University have carried out extensive work on the subject of asset-weighted hedge fund returns (their paper can be found here). Their research goes back to 1980, combines two databases and includes nearly 11,000 hedge funds—making it almost certainly the most comprehensive study of its type. The authors show that from 1990 to 2008 hedge funds generated negligible alpha and that their asset weighted returns were 6%, only slightly above the risk free rate of 5.6% and less than half the traditional time-weighted measure of 12.6% (and no doubt even worse once investors’ costs of research and due diligence are factored in). Just as individual hedge funds have their best returns when they’re small, so has the industry. Few investors enjoyed the high returns of the 1980s and early 1990s that subsequently drew in large amounts of capital. Overall, the research suggests that all the money that’s ever been invested in hedge funds should instead have been put in Treasury bills.
This is a quite staggering result. An entire industry of investment professionals and $2 trillion in assets are dedicated to activities that historically have failed to generate any excess return. This seemed such a huge story that I asked Ilia Dichev how industry professionals had reacted to these findings. He described the response as “moderate,” in part he felt because few investors grasped the difference between time-weighted and asset-weighted returns (IRR); I suspect an additional reason is that so few people in the hedge fund industry would benefit from these conclusions, and of course switching careers from being a hedge fund analyst to, say, an analyst of private equity funds is not a trivial step. But what it means is that the only way for an investor to justify a hedge fund allocation is through a belief that their individual manager selections will perform significantly better than the averages. There’s no other way. Simply earning the benchmark isn’t much use since 28 years of history show that it’s the risk-free rate. Core asset classes such as public equities or high grade corporate bonds justify their inclusion in portfolios through a long history of generating excess returns. Individual stock/bond selection may add or subtract from returns, but value-added security selection need not be present for an equity allocation to make sense. For a hedge fund investor, unless you can do substantially better than average in manager selection it’s best not to bother.
I’ve worked with some very talented hedge fund investors and have watched them demonstrate superior manager selection over many years. The record would suggest that theirs is the skill that investors should be seeking, and that the majority of allocators fail to deliver.
Simon Lack worked at JPMorgan for 23 years and founded the firm’s seeding platform. He now runs Westfield, NJ asset management firm SL Advisors, which invests client capital through separately managed accounts.