In 1990, hedge funds managed approximately $39 billion in assets. Current estimates put hedge fund assets at $2.5 trillion. That miraculous growth, especially in light of the very poor overall performance of the industry, highlights the need for investors to be able to make informed decisions.
This is especially true because most hedge funds also offer more complex risk exposures to factors that determine returns, and can expose investors to greater risks of “black swan” or tail events, illiquidity and valuation uncertainty.
Mila Getmansky, Peter Lee and Andrew Lo, authors of the July 2015 paper, “Hedge Funds: A Dynamic Industry In Transition,” provide a great service by summarizing the academic literature on the industry. The paper, at more than 100 pages, is the most detailed survey I’ve read, and is highly recommended for both practitioners and investors interested in this subject. Following are a few important highlights.
Biases in the Data
There are a number of biases that may arise among hedge-fund returns databases that are not present in other asset-pricing databases in which all securities of a given type are included (e.g., the University of Chicago’s Center for Research in Security Prices (CRSP) stock returns database).
Among them are self-selection bias, backfill (or instant history) bias, survivorship bias, liquidation bias and data revisions (this is from a new paper, “Change You Can Believe In? Hedge Fund Data Revisions,” which appears in the June 2015 Journal of Finance).
Risk Of 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 dying is so great that in 2014, the attrition rate rose to an unprecedented 26 percent. The authors suggest that either the number of hedge funds is declining (the competition has gotten too great to allow for excess profits, or alpha), or that fewer hedge funds are choosing to report their returns to the commercial databases.
A 2008 study investigated performance, risk and capital formation in the hedge fund industry from 1995 to 2004. The analysis found that, over the 120-month sample, the average fund or funds delivered positive and statistically significant alpha only in the 18-month subperiod between October 1998 and March 2000. A 2005 study found that, after adjusting for various hedge fund database biases, hedge funds significantly underperform their benchmarks, on average.
In a sample of 7,000 hedge funds, a 2014 study found that alpha changes dramatically through time and across categories, and is related to the level of competition among hedge funds—not a good sign, given the dramatic increase in assets under management in the industry. This last finding shouldn’t be a surprise since the compound return of the HFRX Global Hedge Fund Index from 2005 through 2014 was only 0.7 percent.
Persistence In Performance
The evidence here is similar to that found in the venture capital industry. While there is little overall evidence of persistence in performance beyond the randomly expected, there’s some evidence of persistence of 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 you’ll have access to the few funds with persistent records of superior performance.
Replication products are sold at a far lower fee level than hedge funds, and the evidence is that many of them seem to live up to their promise of low correlation with market indexes. While the study found that all of them underperformed during the financial crisis of 2007-2009, so did hedge funds over this period. As a result, the authors concluded: “Benchmarked against hedge-fund indexes, many replication products perform well.”
The authors offered up this summary: “The historical data show that hedge funds have not, on average, meaningfully outperformed traditional portfolios of stocks and bonds after fees.”
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.