The Long and the Short of Hedge Fund Returns

January 11, 2006

How did hedge funds perform in 2005? It depends a bit on whom you ask. But one thing is clear: The days of huge returns are behind us.

Hedge funds are supposed to be flashy.  When I think of hedge funds, I think of super-smart managers jet-setting around the world to deliver amazing returns to their ultra-rich investors.  I think of George Soros, and Jim Rogers, and Dan Och; I think of 30 percent compound annual growth (CAGR).

But if that's what I think, I have another think coming. 

The results are in for the hedge-fund industry for 2005, and they aren't pretty.  While different hedge fund indexes posted different returns (they hold wildly different funds), almost all of them lagged the broader global markets.

The Standard and Poor's Hedge Fund Index did the worst, rising just 2.28 percent for the year.  The Hennessee Hedge Fund Index did better, rising 6 percent, while the popular CSFB/Tremont Investable Hedge Fund split the difference, rising 3.48 percent.  The Greenwich-Van Global Hedge Fund Index posted the highest returns of any weighted hedge fund, possibly thanks to its global bent, returning 8.3 percent.

The hedgies put the best possible spin on these numbers.

"Destructive hurricanes, unsurpassed oil prices and continued short-term Fed rate tightening seem to have weighed heavily on the minds of many investors as 2005 progressed," said Wade McKnight, vice president of Greenwich-Van. "However, hedge funds in aggregate delivered the absolute return they target."

Maybe.  But paying big fees for sub-par returns isn't anybody's idea of a good time, and that's what these funds delivered: sub-par returns.

While most of the hedge fund indexes outstripped the 3 percent return of the S&P 500, that's not a fair comparison, since most funds aren't limited to domestic investments.  A better comparison would be a global benchmark, like the S&P Global 1200 or the MSCI World Index: Those indexes rose 7.6 percent and 9.5 percent, respectively, leaving most hedge funds in the dust.

It doesn't even get much better if you drill down to the specific strategy level.  None of the six strategies tracked by the Dow Jones Hedge Fund indexes matched global market returns, and of the five strategies tracked by S&P, only long/short funds even approached global returns, delivering 9 percent growth.

What gives?  The problem, according to many industry watchers, is that there's simply too much money floating around. Hedge fund assets have doubled over the past five years, rising from about $500 million in 2000 to more than $1 trillion.  Hedge fund assets now make up almost 7 percent of total mutual fund assets worldwide, up from just 2.36 percent at the start of 1999, according to the Hennessee group.  And there's simply nowhere for this money to go.

Hedge funds have traditionally thrived on exploiting inefficiencies in the marketplace, often using options and futures strategies to, for instance, make money on small arbitrage opportunities.  But today, all that money is chasing the same returns, and it appears that there just aren't enough inefficiencies in the marketplace for these funds to exploit. 

Toward this end, the flat returns for S&P's arbitrage sub-index are telling. The returns for arbitrage funds have been shrinking steadily over the past few years. The S&P sub-index has posted 4.8 percent average returns over the past five years, 1.5 percent over the past 3, and nothing for the past 12 months. 

Hedge fund experts are quick to point out that hedge funds aim for "absolute returns," and they don't concern themselves with benchmark comparisons. But those absolute returns are shrinking.  As mentioned, the Van-Global Hedge Fund Index was the best performing hedge fund index last year, posting 8.3 percent returns.  But that was barely half of the average 15.5 percent return posted by that index since 1990.

The generous explanation is that volatility is down across all market sectors, and that there are fewer opportunities for fund managers to exploit.  The more likely explanation, if you ask me, is that the room has gotten too crowded … and the best days of the hedge fund industry may be behind us.

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