Swedroe: Hedge Fund Activity No Gauge

March 28, 2018

As I recently observed, hedge funds began 2018 coming off their ninth-straight year of trailing U.S. stocks (as measured by the S&P 500 Index) by significant margins. And for the 10-year period ending 2017—one that included the worst bear market in the post-Depression era—the HFRX Global Hedge Fund Index produced a negative return (-0.4%), underperforming every major equity and bond asset class.

Perhaps even more shocking is that, during this period, the only year in which the global hedge fund index outperformed the S&P 500 Index was 2008. Even worse, when compared to a balanced portfolio allocated 60% to the S&P 500 Index and 40% to the Barclays Government/Credit Bond Index, it underperformed every year.

While their aggregate results are abysmal, especially in light of the fact that there are now about $3 trillion in assets under management at hedge funds, it doesn’t mean there weren’t some hedge funds that managed to outperform appropriate risk-adjusted benchmarks. Nor does it mean investors could identify, in advance, the small minority that did.

Do More Active Hedge Funds Do Better?

Maziar Kazemi and Ergys Islamaj contribute to the literature on hedge fund performance, and its persistence, with their November 2016 study, “Returns to Active Management: The Case of Hedge Funds.”

They investigated whether more active hedge funds performed better than less active hedge funds. In other words, using the Carhart four-factor (market beta, size, value and momentum) model as the basis for comparison, do more active hedge funds provide higher risk-adjusted returns?

Kazemi and Islamaj used a novel, but intuitive, approach to proxy hedge fund activeness. They first estimated the dynamics of factor loadings on a standard, benchmark model, and then used time-varying estimates of risk exposures to construct a measure of activeness for each fund. Their database included a sample of 2,323 live and dead U.S. equity long/short hedge funds for the period 1994 to 2013.

The authors hypothesize: “A priori, it is not clear whether the after-fee performance of the more active funds should exceed those of the less active funds. Fund managers that have skills in the selection of securities may follow a buy-and-hold approach, while those who have skills in timing various segments of the market may follow a more active strategy. However, if both active and less active fund managers are equally skilled, or if markets are efficient, then, because of the transaction costs, we should expect to see lower performance on the part of the active managers.”

Following is a summary of their findings:

  • Hedge funds tend to have positive exposures to the size factor, negative exposure to the value factor and positive exposure to the momentum factor.
  • When performance is measured by raw returns, a monotonic, positive relationship exists between activeness and performance—the more active the fund, the higher the raw return. However, the highly active funds’ returns are more volatile than the least active funds’ returns.
  • For low-to-moderate levels of activeness, the relationship between activeness and risk-adjusted return is negative. As activeness increases, the relationship between activeness and mean alpha turns flat with some notable fluctuations. Finally, for relatively high levels of activeness, there is a noticeable positive relationship between activeness and mean alpha. This relationship turns positive only at the highest levels of activeness.

Kazemi and Islamaj concluded: “If any, only a handful of active managers are successful in generating positive risk-adjusted returns for their funds.” They added: “A more active hedge fund investment strategy is not associated with higher risk-adjusted returns.”

Summary

The preceding findings suggest that, in terms of risk-adjusted returns, hedge fund activeness does not improve performance. It appears that only a handful of highly active managers may be able to overcome the greater transaction costs and generate higher risk-adjusted returns.

An interesting coda to this article is a mention of the $1 million bet that Warren Buffett made in 2007 with Ted Seides, a founder of hedge fund Protege Partners. Buffett bet that, over the next decade, the S&P 500 would beat a basket of hedge funds selected by Protege Partners. The S&P 500 Index fund Buffett chose compounded a 7.1% annual gain over 10 years, beating an average increase of 2.2% by Protege Partners’ basket of funds.

One would think that if anyone could successfully identify in advance which hedge funds would outperform, it would be another highly regarded hedge fund manager.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

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