Swedroe: Hedge Funds Dropping Like Flies

It tends to get lost in the hype, but hedge funds have a pretty high mortality rate.

Reviewed by: Larry Swedroe
Edited by: Larry Swedroe

Fortress Investment Group is closing its flagship hedge fund following heavy losses and investor withdrawals. The fund, which had managed more than $8 billion in 2007, saw its assets fall to $3.2 billion at the start of 2015 and then again to just $1.6 billion at the time of this week’s announcement.

Fortress’s fund, which made bets on shifting macroeconomic trends, lost investors more than 17 percent through the end of September. That’s pretty hard to do, given that not a single major asset class is down that much in 2015. The worst-performing equity asset class so far this year has been emerging markets, which were down about 15 percent.

Fortress’s announcement came on the heels of one by private equity giant Bain Capital, which said it was winding down its multibillion-dollar Absolute Return Capital hedge fund (that also took bets on shifting macroeconomic trends) after three straight years of losses.

The fund lost its investors 14 percent this year through August. The performance of this fund is just another demonstration of the fact that the phrase “absolute return”—at least as it’s used by the hedge fund industry—is an oxymoron.

High Hedge Fund Mortality

Just in case you think these are isolated examples, here’s what the research has found in terms of the risk of a hedge fund “dying.” Approximately 30 percent of new hedge funds don’t make it past 36 months due to poor performance. Almost half of all hedge funds never reach their fifth anniversary. And only about 40 percent survive for seven years or longer. The risk of a hedge fund dying is so great that, in 2014, the attrition rate rose to an unprecedented 26 percent.

What’s truly amazing is that investors have continued to pour money into hedge funds, despite what is now a decade or more of poor performance. The compound return of the HFRX Global Hedge Fund Index from 2005 through 2014 was only 0.7 percent, which was not only well below the return of every major equity asset class across the globe, but even below the return of virtually riskless one-year Treasurys.

And the poor performance of the hedge fund industry has continued into 2015. The HFRX Global Hedge Fund Index was down 3.1 percent through Oct. 10. With the Vanguard S&P 500 ETF (VOO | A-99) down 0.5 percent and the firm’s Total Bond Market ETF (BND | A-94) up 1.2 percent, a balanced portfolio of these two funds (allocated 60 percent to equities and 40 percent to bonds) would have gained 0.2 percent over the same period, outperforming hedge funds by 3.3 percentage points. And that’s without having to invest in any illiquid securities or engage in the use of leverage while at the same time providing investors with daily liquidity (which hedge funds do not).

Hedge funds do offer the hope of outperformance. Unfortunately, the evidence is overwhelming that the hype far exceeds the small chance this hope will become reality.

The one small glimmer for hedge fund investors is some evidence that points to persistence of performance. Here, the evidence is similar to that found in regard to the venture capital industry.

And while there is little overall evidence of persistence in performance beyond the randomly expected, there’s some support for persistence among the very top performers. The bad news for investors is that unless you look in the mirror and see David Swensen, the CIO of Yale’s Endowment (or others in similar positions), it’s not likely that you’ll have access to the very few funds with persistent records of superior performance.

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

Larry Swedroe is a principal and the director of research for Buckingham Strategic Wealth, an independent member of the BAM Alliance. Previously, he was vice chairman of Prudential Home Mortgage.