Swedroe: Hedge Funds Grow, Returns Fall

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.

Reasons For Falling Performance
First, the early successes of hedge funds (when the industry was young and small) attracted more dollars. However, the opportunities to generate excess returns haven’t kept pace with increased AUM. In other words, the “trades” that hedge funds pursue became “crowded,” and the mispricings they were previously able to exploit either shrank or disappeared altogether.

Second, at the same time the supply of capital was increasing, the supply of victims that hedge funds need to exploit in order to generate excess returns (alpha) has been falling—the supply of sheep waiting to be sheared has been shrinking.

As pointed out in my book, “The Incredible Shrinking Alpha,” which I co-authored with Andrew Berkin, the percentage of stocks owned directly by retail investors (considered dumb money) has fallen from about 90% 70 years ago to about 20% today.

And there’s yet a third explanation for the deteriorating performance. The level of competition has increased as today’s institutional money managers are much more highly skilled.

Charles Ellis, who is highly respected in the investment industry, noted: “Over the past 50 years, increasing numbers of highly talented young investment professionals have entered the competition. . . . They have more-advanced training than their predecessors, better analytical tools, and faster access to more information.”

Legendary (or once-legendary) hedge funds such as Renaissance Technologies, SAC Capital Advisors and D.E. Shaw hire Ph.D. scientists, mathematicians and computer scientists. MBAs from top schools, such as the University of Chicago, Wharton and MIT, flock to investment management armed with powerful computers and massive databases. This leads to what is known as the paradox of skill—the tougher the competition, the harder it is to generate performance that distinguishes you from the crowd.

Shrinking Alpha

As further evidence on the deteriorating performance of hedge funds, we can look at the results of a study by William Bernstein, author of the mini-book, “Skating Where the Puck Was.”

Bernstein examined the returns of hedge funds, applying a three-factor analysis to the Hedge Fund Research Global Returns series for the period 1998 through 2012. Bernstein found that while hedge funds did produce large alphas in the first third of the period (when AUM was relatively small) as investor assets chased those returns, alpha shrank and then turned negative.

From 1998 through 2002, the hedge funds produced an incredible alpha of 9.0%. However, from 2003 through 2007, their alphas went to -0.7%. And from 2008 through 2012, the alpha became -4.5%.

The table below provides additional evidence on just how poorly hedge funds have performed. It shows the annualized return of the HFRX Global Hedge Fund Index for the last 10 calendar years—2006 through 2015—as well as the returns of the major equity asset classes and returns to various maturities of Treasury securities.

Perhaps even more shocking is that, over this period, the only year that the HFRX Global Hedge Fund Index outperformed the S&P 500 was 2008. Even worse, compared with a balanced portfolio allocated 60% to S&P 500 Index and 40% to the Barclays Government/Credit Bond Index, it underperformed every single year.

That investors continue to pour money into hedge funds, despite their persistently poor returns over the past decade and even longer, is one of finance’s great anomalies. It can only be explained as the triumph of hype, hope and marketing over wisdom, experience and evidence.

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