Swedroe: Hedge Funds Rip Off Investors

As we have discussed many times, the evidence demonstrates that hedge funds have consistently failed to deliver on their promise of alpha. There is an overwhelming body of research indicating that hedge funds must be ego-driven investments, because there can be no other explanation for why investors continue to pour money down the proverbial drain. The following are only some of the many problems with investing in hedge funds:

• Lack of liquidity due to lock-up periods
• Tax inefficiency because of high turnover
• Non-normal (lotterylike) distribution of returns
• High risk of a fund dying early; the average life span is only about five years
• Lack of transparency
• Agency risk created by incentive structures (mismatched incentives)
• Large biases (survivorship and liquidation) in the data.
• Riskiness of the assets (including the use of leverage)
• No persistence of performance beyond the randomly expected

More Risk

It’s well known that hedge funds take on significantly greater risk by investing both in illiquid securities and security issues of lower credit quality. In addition, many hedge funds use leverage to try and enhance returns. Thus, the alphas reported by these hedge funds are misleading because they use inappropriate (less risky) benchmarks.

For example, a 2003 study, “Hedge Fund Performance 1990-2000: Do the ‘Money Machines’ Really Add Value?” compared the fee-adjusted returns of 77 hedge funds between 1990 and 2000 with the returns generated by a market benchmark with a similar risk profile.

Underperforming Benchmarks

More than 90 percent of the funds failed to outperform their benchmarks.And a 1999 study, “The Performance of Hedge Funds: Risk, Return, and Incentives,” concluded that “hedge funds provided no advantage over indexing on a risk-adjusted basis.”

A 2010 study, “Hedge Fund Return Sensitivity to Global Liquidity,” adds to the literature on the issue of riskiness in hedge funds. The authors found that the Carhart four-factor model (beta, size, value, momentum) has high explanatory power regarding hedge fund returns, meaning it isn’t alpha, but rather exposure to those four factors, that can explain most of hedge fund returns. However, when the authors added a factor for liquidity risk, the explanatory power of the model increased.

What’s more, the explanatory power of the liquidity factor was highly significant. These findings show that most hedge fund strategies have a significantly large exposure to systematic equity risk.

Importantly, the authors found that in times of economic distress, investment funds cannot reduce their exposure to less liquid assets, and thus remain exposed to the market downturn. Another discovery was that strategies using leverage, such as “relative value” strategies, are hardest hit when liquidity dries up.

They also demonstrated that hedge funds offering daily liquidity (as opposed to requiring lockup periods) exhibited lower “loading” on the liquidity factor than hedge funds that don’t. Research in the study confirmed the findings of other papers on the subject.

Paid To Take On Risk

And finally, a 2011 study, “The Economics of Hedge Funds: Alpha, Fees, Leverage, and Valuation,” found that when the fund manager is paid via management and incentive fees, these “high-powered incentive fees encourage excessive risk taking.”

The academic research on hedge funds demonstrates that little is unique about them—hedge fund returns are significantly exposed to systematic equity risk factors. And the addition of liquidity risk increases the explanatory power of the factor model substantially, confirming a significant exposure of hedge funds to liquidity risks.

Lastly, an increase in market illiquidity is associated with a negative return to hedge funds. Just when you need the “hedge” the most, it’s the risks that tend to show up.

Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.