By Andrew Baker
Hedge funds, theirrole within financial markets and the returns they generate have been under considerable debate since the global financial crisis of 2008. Some policymakers have been quick to blame hedge funds for market failures, while some critics have questioned their performance.
A newly published study from the Centre for Hedge Fund Research at Imperial College London, however, uses compelling empirical data backed by detailed analysis to contribute some much-needed objectivity to the debate about the merits of hedge funds. The research — commissioned by KPMG, the international audit, tax and advisory firm, and AIMA — provides powerful proof of hedge funds’ ability to generate stronger returns than equities, bonds and commodities, and to do so with lower volatility and risk than equities and commodities.
The research’s headline finding was that hedge funds achieved an average return of 9.07 percent after fees for the period from 1994 to 2011. That net return compared to 7.18 percent for stocks, 6.25 percent for bonds and 7.27 percent for commodities. The research also demonstrated that hedge funds were significant generators of alpha, or excess returns above a benchmark, creating an average of 4.19 percent per year. And the paper — which included inactive as well as active funds, thereby preventing survivorship bias — found that an equal-weighted hedge fund index returned five times the initial investment after fees.
But the researchers looked beyond simple performance. They found that hedge funds achieved those solid, long-term returns with considerably lower volatility and value at risk than stocks and commodities, and similar volatility and VaR to bonds. Since hedge funds deliver more than one-third higher average returns and significantly higher Sharpe ratios than bonds, the researchers were able to conclude that hedge funds generate superior performance over conventional asset classes.
The study also showed explicitly that an equally weighted portfolio of hedge funds, global stocks and bonds outperforms the conventional 60–40 allocation to stocks and bonds with a significantly higher Sharpe ratio, lower tail risk and substantial diversification benefits.
One of the researchers’ most significant findings related to how industry profits are shared between managers and investors, a topic of much debate lately. The paper confirmed that out of an average gross return over 17 years of 12.61 percent, 9.07 percent went to the investor and 3.54 percent to the manager.
Put another way, 72 percent of the profits went to the investor and 28 percent to the manager. This is a strong rebuttal to those who have suggested that the profit share may be the other way around. Yet it is the logical outcome based on a traditional 2-and-20 fee structure (or for the sake of accuracy, a 1.75 percent and 17.5 percent structure, which is closer to the average).
The study also looked beyond the impact of the industry on investors and weighed questions including the value of the industry to markets and the broader economy. A review of academic literature concluded that hedge funds are important liquidity providers in the markets they are active in, while hedge fund activity has beneficial effects for price discovery, the efficient allocation of capital, financial stability, shareholder value, portfolio diversification and the broader economy.
The researchers also reiterated a point that AIMA has been stressing for some time: The industry’s value can be measured in the fact that it is managing investments from organizations that might be regarded as socially valuable investors, such as pension funds, university endowments, charities and insurance companies. The paper concluded that the ability of hedge funds to deliver superior risk-adjusted returns and better downside protection meant that the industry was playing an important social role as guardians of these investments.
The publication of this study comes during a momentous period for the industry. There has probably never been a time when there has been more interest in — and scrutiny of — the activities of hedge funds, whether by investors, policymakers, regulators or the media. Much of this is welcome and is in the long-term interest of the industry. Performance, fees and transparency have always been pivotal issues, but they have assumed even greater importance since the crisis.
By focusing on a time period of some 17 years, the researchers have been able to present an informed and balanced view. Despite a desire in some quarters to focus on ever-shorter periods of performance, the real picture, as the study shows, is that hedge funds have been a very solid investment for a long time.
Andrew Baker is the chief executive officer of AIMA.