Over the past decade, investors have continued to pour new assets into hedge funds. Total hedge fund assets under management are now greater than $2.6 trillion, and the number of hedge funds continues to grow (current estimates put them in excess of 10,000, more than twice the number there were in 1990).
Consider also that in 1993, the industry was managing less than $40 billion. That means the compound rate of growth of assets under management was over 23% per year. Given the tremendous increase in assets, you’d think that the industry had delivered great returns. Unfortunately, you would be wrong. Persistently over time, the aggregate performance of the industry has deteriorated.
Hedge Fund Performance And Asset Growth
Harlan Platt, Licheng Cai and Marjorie Platt—authors of the study “The Impact of New Capital on Hedge Fund Returns,” which appears in the winter 2015 issue of The Journal of Investing—examined the relationship between the growth of hedge fund assets and performance.
They analyzed the aggregate performance of nine different hedge fund styles for which data was available (convertible arbitrage, dedicated short bias, emerging markets, equity market neutral, event-driven, fixed-income arbitrage, fund of funds, global macro and long/short) over the period 1994 through June 2013.
The authors found that the compound rate of growth in assets in the nine hedge fund categories ranged from about 20% per year to more than 70% per year (in the case of convertible arbitrage).
However, when they split the full period into two equal parts, they discovered “a strong negative relationship between hedge fund returns and their AUM.” They concluded: “Hedge fund returns are falling.” The authors also found their results held true for both market-neutral and directional funds.
What explains the decline in performance? A naive explanation would be that today’s hedge fund managers simply are not as smart as their predecessors. This seems completely illogical, given that multibillion-dollar compensation levels for successful hedge fund managers have lured into the industry the best and brightest students and practitioners.
If the level of skill were driving returns, we should have seen improving returns, not declining results. There are, however, very logical explanations for the deteriorating performance.