The Five Reasons Hedge Funds Underperform
Hedge fund performance — and underperformance — is a complex, nuanced issue which many folks misunderstand.
Bloomberg, December 9, 2013
“The $2.5 trillion hedge-fund industry, whose money managers are among the finance world’s highest paid, is headed for its worst annual performance relative to U.S. stocks since at least 2005.
The funds returned 7.1 percent in 2013 through November, according to data compiled by Bloomberg. That’s 22 percentage points less than the 29.1 percent return of the Standard & Poor’s 500 Index, with reinvested dividends, as markets rallied to records.”
–Hedge Funds Trail Stocks by the Widest Margin Since 2005, Bloomberg
Hedge fund performance — and underperformance — is an area of research I have been intrigued about for several years now. It is a complex, nuanced issue which many folks misunderstand.
The numbers cited above are eye-popping: The average hedge fund is underperforming the S&P 500 by more than 2000 basis points this year alone. That is an astonishingly poor showing. As Saijel Kishan & Kelly Bit point out in the Bloomberg News article, hedge funds have “underperformed the S&P 500 by 97 percentage points since the end of 2008.” The last time the fund industry outperformed U.S. stocks was in 2008. That year, they lost (depending on what industry data you use) somewhere between 19 and 29 percent; the S&P 500 declined 37 percent. Prior to 2008, you need to go back to 1993 to find similar outperformance, when they were up 31 percent versus a 10 percent increase for the S&P.
In a presentation at the retirement security conference at the Kennedy School of Governmentat Harvard University this summer (The High Cost of Neuro-Financial Errors: How Cognitive Bias and Performance Chasing leads to Investing Failures), I divided the explanations for hedge fund performance into five categories: 1) Industry Size; 2) Fund Size; 3) Unhedged Hedge Funds and the Financial Crisis; 4) Drag from Fees; 5) Unsmooth Alpha Distribution. A brief look at each will put the poor performance into some context.
1. Industry Size: The Hedge fund industry has swollen, from barely $100 billion dollars in 1997 to over $2.5 trillion dollars in 2013. Where there once was a few hundred fund managers, there are now about 10,000.
This enormous growth has hurt Alpha generation several ways. As with the expansion in professional sports teams, there is just not enough All-Star quality talent to go around. Once we passed a fixed number of fund managers — and my suspicion is that this number is below 1,000 — the rest of the pack is only fair to middling.
Second, Alpha may simply be a limited resource. It appears that there are not enough market inefficiencies to be identified and exploited by the industry since it swelled up beyond a certain size.
2. Fund Size: Several studies have identified an inverse relationship between the size of a successful hedge fund and its manager’s ability to create Alpha. As monies have flowed into successful, Alpha-generating funds, it impairs their ability to continue their outperformance. Some become closet indexers, others force their way into lesser-probability trades. Either way, in most cases, increased assets under management typically leads to weaker performance.
3. Unhedged Hedge Funds: Perhaps it’s a misnomer to call them hedge funds: One of the biggest changes over the past decade is that the typical hedge fund is unhedged. They are perhaps better described as highly leveraged active trading vehicles.
In years where funds are largely exposed to rallying markets, the lack of hedging does not hurt performance; indeed, it even enhances it. But in years such as 2008, many hedge funds suffered enormous losses. Across the entire industry, according to Simon Lack, author of “The Hedge Fund Mirage,” they lost all of the profits they had previously made (and then some).
4. The Drag of 2 Percent & 20 Percent: The enormous drag of high fees is an extreme challenge to overcome. Studies of mutual funds have shown that even when all other things are not equal, investors are better off with the cheaper fee fund. High fees compounded over time degrade performance as well. According to Opalesque, in 2013, hedge fund industry compensation has risen for the third consecutive year. Others (including Lack, above) have called funds a “giant wealth-transfer machine,” moving assets from investors to managers.
5. Non-Gaussian Alpha Distribution: We have a tendency to think of most data distributions as a smooth and symmetrical bell curve. But as it turns out, that is not how performance actually shows up. A handful of large outliers typically trounce the rest of the industry numbers.
Take out the superstars, and you are left with an expensive, below-benchmark industry. The witticism that sums this up: “Come for the high fees; stay for the underperformance.”
One final factor worthy of its own column is the many behavioral factors that make selecting any active manager so daunting. Typical institutional investors must confront their own biases when selecting any high-cost fund manager — be it an emerging hedge fund or venture capital or private equity manager. Suffice it to say that too many investors look at past performance, rather than a fund manager’s process. All that tells you is who outperformed previously, and not necessarily who is going to outperform in the future.
This is an issue worth tracking, as the industry continues to paradoxically attract capital as it underpeforms. It is an area of investment management that may be ripe for disruption.
I originally published this at Bloomberg, December 9, 2013. All of my Bloomberg columns can be found here and here.