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.
Studying the performance of hedge funds over the period 1996-2010, the authors came to the following conclusions:
- Simple strategies that write naked put options on equity indexes can be used to replicate broad hedge fund indexes. They found that “the put-writing strategies match the losses during the fall of 2008 and the LTCM crisis, the flat performance during the bursting of the Internet bubble, as well as the strong returns during boom periods. While the put-writing strategy fails to explain some of the return variation in economically benign times like the bull market between 2002 and 2007, it captures the variation in economically important times remarkably well.” In other words, there’s no reason to pay high fees for accessing the attributes of hedge funds.
- Once returns are properly adjusted for risk, hedge funds earned returns that are statistically indifferent from zero—in other words, they don’t generate alpha. The results indicate that sophisticated investors have barely covered their properly computed cost of capital. And that result comes with the caveat that the data set used has survivorship bias.
- Put options could be said to be “expensive” in that they generate alpha in typical models of about 4 percent. However, that could simply be a function of high risk aversion of investors, meaning they’re concerned about the severe losses possible in the left tail. That, in turn, explains the high returns to strategies that accept left tail risk—at least high before adjusting for the risk.
The authors concluded: “The risks borne by hedge fund investors are likely to be positive net supply risks that are unappealing to average investors, such that they may earn a premium relative to traditional assets. A distinguishing feature of many of these risks is that their payoff profiles have a distinct possibility of being nonlinear with respect to a broad portfolio of traditional assets. These nonlinearities can arise either directly from the underlying economic risk exposure (e.g. credit risk, merger arbitrage), or through the institutional structure through which they are borne (e.g. funding liquidity).”
The takeaway from that somewhat-technical verbiage is this: Forewarned is forearmed.
Larry Swedroe is director of Research for the BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.