The investment successes of the Yale Endowment led many other endowments, foundations and even high-net-worth individuals to consider adopting the so-called "Yale Model." The model included a focus on alternative investments and attempts to capture the liquidity premium available in illiquid investments, such as private equity and hedge funds.
In his new book, Asset Management: A Systematic Approach to Factor Investing, author Andrew Ang includes two chapters that take an in-depth look into hedge funds and private equity. While I recommend that investors read the entire book, today we'll review Ang's take on hedge funds. We'll follow that with a separate post covering his treatment of private equity.
In addressing an important point on the composition of hedge funds, Ang quotes John Cochrane, a well-known finance professor at the University of Chicago: "Hedge funds are not a new asset class…they trade in exactly the same securities you already own."
In terms of reported returns, Ang takes the time to describe the many biases in hedge fund databases, including both survivorship bias (most researchers estimate this at about 3 percent to 4 percent) and backfill bias (estimated to be as high as 7 percent). And the risk of a hedge fund dying is very high. Between 10 percent and 15 percent of hedge funds vanish from the databases annually. That's about twice the death rate of mutual funds. What's more, fewer than 5 percent of hedge funds last more than 10 years.
Ang also notes that a lot of the hedge-fund data is simply too good to be true. In fact, there's evidence that funds tend to smooth the data (making their returns seem less volatile and appear less risky) by underreporting their returns early in the year.
Alphas Have Turned Negative
When it comes to performance, there's evidence that hedge funds were able to generate alpha when the industry had relatively small amounts of assets to manage. And that's what got investors interested. Twenty years ago, hedge funds managed about $300 billion. Today, they manage closer to $3 trillion. And the alphas have turned negative. Consider the following evidence, which is not contained in Ang's chapter.
William Bernstein, author of the mini-book, Skating Where the Puck Was, examined the returns of hedge funds, applying a three-factor analysis to the Hedge Fund Research Global Returns series for the period from 1998 through 2012. Bernstein found that from 1998 through 2002, hedge funds produced an incredible alpha of 9.0 percent. However, from 2003 through 2007, their alphas went to -0.7 percent. And from 2008 through 2012, the alpha became -4.5 percent.
As shown in the table below, the performance of hedge funds for the 10 calendar years from 2005 through 2014 has been so bad that, in returning just 0.7 percent per year, they managed to underperform every major asset class, including virtually riskless one-year Treasurys.
Ang cited the study "Higher Risk, Lower Returns," which found that hedge funds had underperformed the S&P 500 Index by almost 5 percent per year from 1980 through 2008, and just barely outperformed the returns to one-month T-bill over that period. He also noted that there's little evidence of any persistence of outperformance (except for the fact that the poorest-performing hedge funds show a tendency to repeat it). As a result, it does little good to know that there are a few hedge funds that have outperformed in the past.
Importantly, Ang observes that any evidence of persistence is in small and young funds. The problem is that as assets under management grow, performance tends to deteriorate. Larger funds underperform the average fund. psumably, they got large due to cash flows after the good performance.
In terms of risk, Ang notes that the average hedge fund shows high correlations with the market factor. And this is true for hedge funds that operate in the emerging markets and employ event-driven strategies.
He also shows that hedge fund returns tend to correlate with volatility, as well as other common factors (such as the term and default pmiums). In other words, there really isn't much special about hedge funds, which is the point John Cochrane was making.
Adding to the risk problem is that hedge funds restrict liquidity, which can be costly.
Low Liquidity, Frightfully Expensive
Ang himself estimated that the cost of a three- to six-month lock-up is around 2 percent. A two-year lock-up would be worth 4 percent. Investors should be compensated for taking such risks. Since hedge funds typically take more risk than the risk entailed in, say, an investment in the S&P 500, the extra risk must be accounted for when comparing returns. The returns should be risk-adjusted before determining if any alpha actually exists.
Ang also notes that incentive fees, which in theory are supposed to align the manager's interest with that of the investor, encourage risk taking. If the risks pay off, the managers win big. But if they don't, the managers still collect their 2 percent fee. And the high fees certainly aren't in an investor's interests.
Ang cited work by one of his students, which concluded that the typical 2 and 20 hedge fund fee structure was the equivalent of a 6.4 percent management fee. How many managers have generated true risk-adjusted alphas even close to that over the long term?
The Experts Pile On
The best way to summarize the evidence on hedge funds is with the following quotations. The first observation comes from Cliff Asness of AQR Capital:
"Hedge funds are investment pools that are relatively unconstrained in what they do. They are relatively unregulated (for now), charge very high fees, will not necessarily give you your money back when you want it, and will generally not tell you what they do. They are supposed to make money all the time, and when they fail at this, their investors redeem and go to someone else who has recently been making money. Every three or four years they deliver a one-in-a-hundred year flood. They are generally run for rich people in Geneva, Switzerland, by rich people in Greenwich, Connecticut."
The next comes from David Swensen, chief investment officer of Yale University, in his book, Unconventional Success:
"In the hedge fund world, superior active management constitutes a rare commodity. Assuming that active managers of hedge funds achieve success levels similar to active managers of traditional marketable securities, investors in hedge funds face dramatically higher levels of prospective failure due to the materially higher levels of prospective failure due to the materially higher levels of fees."
And finally, my personal favorite from an interview professor Eugene Fama did with Bloomberg back in 2002:
"If you want to invest in something (hedge funds) where they steal your money and don't tell you what they're doing, be my guest."
If you are interested in learning more about hedge funds and their performance, my books, The Quest for Alpha and The Only Guide to Alternative Investments You'll Ever Need, each contain a chapter that discusses the issues related to investing in them, as well as the findings from academic research on how they have performed.
Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.