No matter how you slice it, hedge funds seem like a rip-off, Swedroe says.
There are many well-documented problems with investing in hedge funds, and it's hard to know where to start in pointing them out.
Among them are: lack of liquidity; lack of transparency; loss of control over the asset allocation and thus risk of the portfolio; non-normal distribution of returns (they exhibit excess kurtosis and negative skewness); and they have a high risk of dying (12.3 percent per year from 1994 through 2008).
Also, many invest in highly risky assets—creating problems when comparing with appropriate benchmarks—and returns have not been commensurate with the risks. They also tend to be highly tax inefficient, and their risks tend not to combine well with the risks of equities.
Not least, there's no evidence of persistence in performance beyond the randomly expected, and their compensation structure creates agency risk, which is to say the incentives between the managers and investors are not aligned, which can lead to excessive risk taking.
And there are well-known biases in the data. Each of the following contributes significantly to a overstating of the actual returns earned by investors.
- Self-reporting bias occurs because poorly performing funds are less likely to report.
- Backfill bias occurs when funds with good performance during their incubation periods are added to databases.
- Liquidation, or delisting, bias occurs when funds that become defunct fail to report their last returns.
- Survivorship bias occurs when poorly performing funds disappear from the database of "live" funds.
Philippe Jorion and Christopher Schwarz, authors of the study "The Delisting Bias in Hedge Fund Databases," which appears in the winter 2014 edition of the Journal of Alternative Investments, used information from three hedge fund databases with about 10,000 pairs of hedge funds to provide direct estimates of the amount of delisting bias.
The most famous example of a hedge fund that terminated its reporting because of serious negative performance is Long Term Capital Management. The managers of that fund managed to lose 92 percent of the invested capital from October 1997 through October 1998, and did not report that loss to public databases.
The authors note that while the delisting bias is impossible to assess from the information in one database only—they found funds delisted in one database often continue to report returns to another—they were able to build an estimate of the delisting bias. Following is a summary of their conclusions:
- 12.3 percent of funds delist per year, on average.
- The delisting bias is greater for smaller funds solely due to their higher death rate, which goes from 20.2 percent for small funds to 5.5 percent for large funds.
- The average omitted delisting loss is approximately 3.5 percent per fund, and 5 percent of omitted delisting losses are greater than 35 percent.
- By tracking the typical performance of a fund that disappears in one database in others, they estimated a lower bound for the delisting bias of 0.35 percent per year across all funds, live and dead.
- 0.35 percent is only a lower bound because it ignores situations where the fund manager decides to stop reporting to all databases.
- They inferred an upper bound for this delisting bias of approximately 1 percent a year.
- The performance of hedge fund indices should be adjusted downward by about 0.5 percent a year to account for the delisting bias. This is still an estimate because it relies on self-reporting. Jorion and Schwarz note that the bias can help explain the systematic differences between the performance of the average hedge fund and that implied by funds of funds—once the extra fees of funds of funds are accounted for. Funds of funds cannot backfill the performance of their underlying funds, nor can they hide the performance of funds that perform poorly or fail. Avoiding the bias makes the funds-of-funds data more reliable.
With this information in mind, let's take a look at the performance of hedge funds. In 2013, the HFRX Global Hedge Fund Index earned 6.7 percent. The table below shows the returns for various equity and fixed-income indices.
|Benchmark Index||2013 Return (%)|
|MSCI US Small Cap 1750 (gross dividends)||39.1|
|MSCI US Prime Market Value (gross dividends)||31.9|
|MSCI US Small Cap Value (gross dividends)||33.7|
|Dow Jones Select REIT||1.2|
|MSCI EAFE (net dividends)||22.8|
|MSCI EAFE Small Cap (net dividends)||29.3|
|MSCI EAFE Small Value (net dividends)||31.6|
|MSCI EAFE Value (net dividends)||23.0|
|MSCI Emerging Markets (net dividends)||-2.6|
|Merrill Lynch One-Year Treasury Note||0.3|
|Five-Year Treasury Notes||-1.1|
|20-Year Treasury Bonds||-1.14|
The HFRX Global Hedge Fund Index underperformed all but two (U.S. REITs and Emerging Markets) of the major equity asset classes. An all-equity portfolio with 50 percent international/50 percent domestic, equally weighted within those broad categories, would have returned 24.2 percent. Also, a 60 percent equity/40 percent bond portfolio with those weights for the equity allocation would have returned 14.6 percent using one-year Treasurys, 14.1 percent using five-year Treasurys and 10.0 percent using long-term Treasurys.
Given the freedom to move across asset classes that hedge funds tout as their big advantage, one would think "advantage" would show up.
Over the long term, the evidence is even worse. For the 10-year period from 2004-2013, the HFRX Index returned 1.0 percent per year, underperforming every single equity and bond asset class. The table below shows the returns of the various indexes:
Annualized Returns 2004-2013
|Domestic Indexes||Return (%)|
|MSCI US Small Cap 1750 (gross dividends)||10.4|
|MSCI US Prime Market Value (gross dividends)||7.4|
|MSCI US Small Cap Value (gross dividends)||9.4|
|Dow Jones Select REIT||8.2|
|MSCI EAFE (net dividends)||6.9|
|MSCI EAFE Small Cap (net dividends)||9.5|
|MSCI EAFE Small Value (net dividends)||10.1|
|MSCI EAFE Value (net dividends)||6.8|
|MSCI Emerging Markets (net dividends)||11.2|
|Merrill Lynch One-Year Treasury Note||2.1|
|Five-Year Treasury Notes||4.3|
|20-Year Treasury Bonds||6.1|
Perhaps even more shocking is that over this period, the only year that the HFRX index outperformed the S&P 500 was 2008. Even worse, compared with a balanced portfolio of 60 percent S&P 500 Index/40 percent Barclay's Government/Credit Bond Index, it underperformed every single year.
For the 10-year period, an all-equity portfolio with 50 percent international/50 percent domestic, equally weighted within those broad categories, would have returned 9.2 percent per year. And a 60 percent equity/40 percent bond portfolio with those weights for the equity allocation would have returned 7.1 percent per year using one-year Treasurys, 8.2 percent per year using five-year Treasurys, and 9.4 percent per year using long-term Treasurys.
The poor performance of the industry raises the question, Why is so much capital invested in hedge funds? One explanation is that it's the triumph of hope, hype and marketing over wisdom and experience.
I also believe that the behavioral explanation of the desire to be a member of a special club explains the large amount of capital investment in hedge funds. Meir Statman, a leader in the field of behavioral finance, explains: "Investments are like jobs, and their benefits extend beyond money. Investments express parts of our identity, whether that of a trader, a gold accumulator, or a fan of hedge funds… We may not admit it, and we many not even know it, but our actions show that we are willing to pay money for the investment game. This is money we pay in trading commissions, mutual fund fees, and software that promises to tell us where the stock market is headed."
Statman goes on to explain that some invest in hedge funds for the same reasons they buy a Rolex or carry a Gucci bag with an oversized logo—they are expressions of status, being available only to the wealthy.
He also explains that hedge funds offer what he called the expressive benefits of status and sophistication, and the emotional benefits of pride and respect. He cites the cases of investors who complain when hedge funds lower their minimums.
Those expressive benefits explain both why Bernard Madoff was so successful and why high net worth individuals continue to invest in hedge funds despite their lousy performance—they are ego-driven investments, with demand fueled by the desire to be a "member of the club."
With that in mind, investors in hedge funds would be well served to consider the following from another leader in the field of human behavior, Groucho Marx: "I don't care to belong to any club that will have me as a member."
Larry Swedroe is director of Research for the BAM Alliance, which is part of St. Louis-based Buckingham Asset Management.