Hedge fund returns can be attractive, but they’re not worth the risk incurred.
The well-publicized returns of the Yale Endowment Fund led many institutions and high net worth investors to add alternative investment strategies to their portfolios, often allocating significant amounts to such investments.
For example, as of June 2010, the Ivy League endowments had 40 percent of their combined assets allocated to non-traditional assets. Unfortunately, many of the strategies, such as hedge funds, typically come with very high expenses, such as a 2 percent annual management fee and 20 percent of the profits. Two important questions about hedge fund strategies are:
1) Do such strategies generate sufficient returns to cover their risk-adjusted cost of capital?
2) Can the strategies be replicated in a more cost-effective way?
Jakub W. Jurek and Erik Stafford, authors of the paper “The Cost of Capital for Alternative Investments,” sought the answers to these questions.
Among their most important findings was that many of the strategies employed by hedge funds are the equivalent of “picking up nickels in front of steamrollers.” In other words, they tend to do well most of the time, but are subject to occasional crashes that can wipe out profits. In technical terms, they exhibit excess kurtosis (fat tails) and negative skewness (values to the left of the mean are fewer but further from the mean).
Also, the crashes tend to happen at the worst of times because many hedge fund strategies explicitly bear risks that tend to be realized when economic conditions are poor and when the stock market is performing poorly. Due to investor loss aversion, assets that perform poorly in bad times should carry large risk premiums.
In other words, such investments should be required to provide very large returns relative to commonly used benchmarks such as the S&P 500 Index. In addition, many of these investments are illiquid, and, thus, should carry risk a risk premium for illiquidity.
Another important issue that wasn’t covered in the paper is that one of the touted benefits of many alternative strategies is their low correlation to equities. There are two problems with this. The first is that while the correlations may be low on average, they tend to turn high at exactly the wrong time, such as in 2008 and in 1998 during the Long Term Capital Management crisis.
A second problem is that low correlations only help if you can actually rebalance, which requires liquidity, and that can be an issue with some hedge fund strategies.