Swedroe: Distinctive Hedge Funds Still Lag

As I have explained before, the holy grail for which many investors are searching is the ability to identify in advance which of the very few actively managed funds will go on to outperform in the future.

An overwhelming body of research has demonstrated that past performance not only doesn’t guarantee future performance, it has virtually no value whatsoever as a predictor. The only value of past performance seems to be that poor performance tends to persist—with the likely explanation being high expenses.

Believers in active management were offered hope that the holy grail had been found with the publication, in the September 2009 issue of The Review of Financial Studies, of a paper by Martijn Cremers and Antti Petajisto, “How Active Is Your Fund Manager? A New Measure That Predicts Performance.”

The authors concluded: “Active Share predicts fund performance: funds with the highest Active Share significantly outperform their benchmarks, both before and after expenses, and they exhibit strong performance persistence.”

Active share is a measure of how much a fund’s holdings deviate from its benchmark index, and funds with the highest active shares tend to have the best performance.

Thus, while there’s no doubt that, in aggregate, active management underperforms, and that the majority of active funds underperform every year (and the percentage that underperform increases with the time horizon studied), if an investor is able to identify the few future winners by using active share as a measure, active management can be the winning strategy. Unfortunately, subsequent research has found active share is not a good predictor of future mutual fund performance.

Hedge Funds & Active Share

Ekaterini Panopoulou and Nikolaos Voukelatos contribute to the literature on the performance of hedge funds, and indirectly on active share, with their October 2017 study, “The Role of Strategy Distinctiveness in Hedge Fund Performance.”

They observe that hedge funds are able to charge investors high fees based on the expectation they will deliver superior performance. This superior performance must be driven by fund managers possessing unique skills that allow them to pursue unique investment ideas.

Panopoulou and Voukelatos tested this hypothesis by examining whether hedge funds with high degrees of distinctive strategy showed persistent outperformance. Their measure of strategy distinctiveness is based on a fund’s return-distance (a measure similar to active share, and the distance of a fund’s return from the mean return of its cohort, scaled by the mean distance among all the cohort’s funds).

They label this measure the fund’s dispersion contribution index (DCI). They then examined whether higher levels of strategy distinctiveness are associated with superior performance after accounting for the fund’s risk exposure.

DCI offers the following benefits: First, it’s a logical choice, as a fund manager can only substantiate the claim of delivering value through unique strategies by offering returns that deviate from peers. Second, the data is readily available, with no need to observe a hedge fund’s holdings.

Their study covered the period January 1994 to August 2015, and included almost 23,000 unique funds. Following is a summary of their findings:

• While the DCI for the majority of funds is less than 1, a small number of funds have particularly high DCI levels.
• The DCI of an individual fund is considerably persistent over time.
• The DCI is significantly related to other fund characteristics. Higher DCI levels are more likely to be observed in funds with higher return volatility, longer redemption notice and lockup periods, higher performance fees, lower age and higher leverage.
• While funds with the highest (lowest) DCI indeed have provided the highest (lowest) net returns, when other sources of risk and other fund-specific characteristics were accounted for, there was strong evidence that more-distinctive funds underperformed relative to their less-distinctive peers. The higher raw returns were accompanied by greater idiosyncratic risks, greater volatility and greater downside risks, and the overall trade-off was negative. These results were robust to various measures of risk-adjusted returns and to other tests (such as equal-weighting or value-weighting).

Panopoulou and Voukelatos concluded: “Overall, our empirical results cast doubt on the presumption that pursuing a distinctive strategy leads to improved performance. Unique strategies seem to involve substantially higher levels of risk exposure without offering sufficiently higher returns, especially after taking into account funds’ idiosyncratic characteristics.”

They added: “Our results could indicate that managers who are skilled enough to implement unique strategies are exploiting the option-like features of their compensation contracts by increasing downside risk in pursuit of extremely high returns.”

This finding is consistent with academic literature that has found fund managers who are judged against benchmarks have an incentive to own higher-beta (riskier) stocks. Additionally, managers’ bonuses (incentive fees) are options on the performance of invested stocks, and thus more valuable for high-volatility investments. It also calls into question the use of performance fees and the perverse incentives they can create.

Hedge Fund Performance

Hedge funds entered 2017 coming off their eighth-straight year of trailing U.S. stocks (as measured by S&P 500 Index) by significant margins.

For the 10-year period from 2007 through 2016, the HFRX Global Hedge Fund Index lost 0.6% per year, underperforming every single major equity and bond asset class. As you can see in the following table, the underperformance ranged from 0.4 percentage points when compared to the MSCI EAFE Value Index to as much as 8.8 percentage points when compared to U.S small-cap stocks.

Perhaps even more shocking is that, over this period, the only year the hedge fund index outperformed the S&P 500 Index was 2008. Even worse, compared to a balanced portfolio of 60% S&P 500 Index and 40% Barclays Government/Credit Bond Index, the hedge fund index underperformed every single year.

For the 10-year period, an all-equity portfolio allocated 50% internationally and 50% domestically, equally weighted in the asset classes within these broad categories, would have returned 4.1% per year. And a 60% equity/40% bond portfolio with those same weights for the equity allocation would have returned 3.0% per year using one-year Treasuries, 4.1% per year using five-year Treasuries and 5.1% per year using long-term Treasuries. All three dramatically outperformed the hedge fund index.

Summary

Panopoulou and Voukelatos’ findings are particularly discouraging for hedge fund investors. While the overall industry had performed poorly, perhaps there was a way to identify ahead of time the few future winners. Unfortunately, we now know that neither past performance nor DCI (or active share) provides that clear crystal ball.

The bottom line is that the evidence suggests investors are best served to think about hedge funds as compensation schemes, not investment vehicles.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.