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Stop Investing In Hedge Funds Now! Oh No, Wait A Minute…

Here’s the other side of the hedge fund debate that has been raging in recent weeks.  In case you haven’t been paying attention, a number of well known media outlets have published articles that have argued that hedge funds aren’t all they’re cracked up to be.  I’ve been pretty hard on hedge funds as well (see here) and firmly believe that hedge funds are largely replicating many of the poor trends seen in mutual funds.  That doesn’t mean all hedge funds are bad or that all mutual funds are bad, but as a general rule of thumb I think it’s safe to say that an index of hedge funds won’t add much value over a highly correlated index fund counterpart after you account for taxes, fees and other frictions.

Anyhow, dvegadtime was kind enough to let me republish his piece from last week which I think is extremely well thought out and certainly worth a read.  As always, feel free to use the comments to discuss.

Stop Investing In Hedge Funds Now! Oh No, Wait A Minute…

By dvegadtime:

“Don’t Invest in Hedge Funds” is probably the refrain you have been hearing and reading over and over again recently. The so-called “smart money” has been under attack as it has failed to beat the market and deliver juicy returns. Some hedge fund managers were harshly criticized because of their attacks on the FED and the monetary policies it has executed in recent years. While the reasons for their hatred towards Bernanke could originate from their trading positions (as Brad DeLong explained in this post) we should bear in mind that one size does not fit all. Blaming the hedge fund category as a whole is not only wrong, but silly.

First of all, accurately quantifying the returns of hedge funds is very hard, if not impossible. For the simple reason that, the large majority of them do not disclose their performances to the public. Matthew O’Brien, in his latest piece for the Atlantic, used a performance chart looking over only ten years and the HFRX index as if this is an index of hedge funds (like the S&P 500 for stocks for example). But that’s wrong. The HFRX shows the return of an index that attempts to track broad hedge-fund performances through the most diffused hedge fund strategies. Several indices which track hedge funds strategies have been constructed to try to replicate their performances. But this is not an easy task! With a lot of limitations. Robert Frey (Professor at Stony Brook University) and myself, find the EDHEC index much more representative than the HFRX. The EDHEC index takes into account the high fees (1% fixed fee of all assets, 10% of all profits), which have been heavily criticized. This finds Matthew and myself in agreement. If we take a look at the cumulative return over the 2000-2013 time window we can see that:

EDHEC file

Chart 1 – Courtesy of Robert Frey

And if we enlarge a little bit the time horizon, here is how the hedge fund performances look like:

HF112

Chart 2 – KPMG, AIMA, Centre for Hedge Funds Research

It seems like hedge funds have performed pretty well over a longer period of time. The two charts emphasize the big losses hedge funds incurred during the financial crisis. From Chart 1, we can also see that hedge funds have recently struggled a little bit to generate “abnormal” returns against the S&P 500. One could say “but it does not tell me anything about the risk taken by the industry, performances are not risk-adjusted” and this is of course a reasonable objection. However, it is almost impossible to measure the risk-adjusted returns of hedge funds because any measure of risk-adjusted returns is hocus pocus. Hedge funds have quantitative and qualitative risks that make them unique to evaluate and analyze. Someone else could say “An equally split (50%-50%) stock/bond hedge fund would have done better than the 60%-40% stock/bond portfolio”. Reasonable too. Objections can be many! But let’s focus for a moment on the recent performances. Hedge funds lost a lot of money during the crisis and let’s admit that they haven’t been able to beat the market recently. Are those good excuses not to invest in hedge funds? In my opinion no, and here is why.

We are missing three very important points here:

1. Hedge Funds provide diversification. Investment strategies of hedge funds vary vastly. To list a few: directional strategies, market-neutral strategies, equity long/short strategies, event driven funds, macro strategies, fixed income arbitrage, short bias etc. A lot of hedge funds try to achieve positive returns using strategies that move in the opposite direction of the major market indices. They therefore suit perfectly for diversification purposes. Risk, the premier journal for risk managers, found that 10 to 15 hedge funds are needed for optimum portfolio diversification:

risk

 

2. Hedge funds can improve an investor’s overall return. It’s pretty common to think of hedge funds as risky bets. But hedge funds can be used for several purposes. There are in fact, low-volatility hedge funds that can enhance returns at limited costs. Or alternatively, returns can be boosted by using hedge funds that particularly focus on high-return strategies by trading volatile products. Generally speaking, investors look at hedge funds as dynamic and flexible investment vehicles able to be traded under several market circumstances. And when implemented in a portfolio with proper due diligence and awareness of the risks involved, benefits may be several.

HF113

KPMG, AIMA, Centre for Hedge Funds Research

3. Continued interest in hedge funds has never diminished, regardless of the recent negative performances and the adverse articles on the media. The asset under management stands at around $2.375 trillion. Compared to the $100,000 first investment in the first hedge fund under Alfred Winslow Jones in 1949, that should equate to a 30.39% annualized growth rate in AUM. If hedge funds have had such a high growth rate, it would indicate much better performance over time (see Chart 2), especially given the fact that they haven’t been able to, historically speaking, advertise. Prequin data shows that 60% of institutional investors, primary source of capital for hedge funds stated in 2013 that they are looking to increase their hedge fund allocation. And this should not be surprising, given the current macroeconomic environment and how hysterically investors have looked for yield in the last year or so. Investors, in fact, are getting prepared for both growth and volatility and use hedge funds as a way to access “dynamic and interconnected markets and to mitigate the risk inherent in these exposures”. Like in point 2, the flexibility of these instruments is something that investors demand.

HF5
One big problem for the industry as whole, now that some hedge funds will be able to advertise themselves, may be the pollution coming from people who are largely incompetent, crooks, or whoever does not use the most up-to-date financial tools. An investor should be able to pick the good hedge funds. Investing in hedge funds because something is called “hedge fund” should be strongly avoided. And this is easier said than done.  An investor carries together with the trade its own risk attitude as well as its own grade of financial sophistication, with a trade-off between the two.

Dreaming double figures returns is easy. Finding ways to systematically trade is harder.

Taking Matthew O’Brien’s paradox to the extreme, what’s worse? Rich people blowing money in hedge funds that are highly inaccessible to retail investors or the same retail investors being harmed by mutual funds that take fees from them but don’t deliver alpha?

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