Swedroe: A Tipping Point For Hedge Funds

March 11, 2015

In 2014, the HFRX Global Hedge Fund Index lost 0.6 percent, underperforming the S&P 500 Index by 14.3 percentage points. And while the index outperformed foreign equities, which generally lost between about 2 and 5 percent, it underperformed virtually riskless one-year Treasury notes, which returned 0.2 percent. It also underperformed a typical, globally diversified and balanced portfolio allocated 60 percent to stocks and 40 percent to bonds.

 

Over the long term, the evidence is even worse. For the 10-year period from 2005 through 2014—which includes the worst bear market in the post-Great Depression era—the HFRX index returned just 0.7 percent per year, underperforming every single major equity and bond asset class. The table below shows returns to various indexes.

 

Assorted Index Returns

Benchmark Index 2005-2014
Annualized
Returns (%)
   
HFRX Global Hedge Fund Index 0.7
   
Domestic Indexes  
S&P 500 7.7
MSCI US Small Cap 1750 (gross dividends) 9.0
MSCI US Prime Market Value (gross dividends) 7.2
MSCI US Small Cap Value (gross dividends) 7.9
Dow Jones Select REIT 8.1
   
International Indexes  
MSCI EAFE (net dividends) 4.4
MSCI EAFE Small Cap (net dividends) 6.0
MSCI EAFE Small Value (net dividends) 6.4
MSCI EAFE Value (net dividends) 3.9
MSCI Emerging Markets (net dividends) 8.4
   
Fixed Income  
Merrill Lynch One-Year Treasury Note 2.0
Five-Year Treasury Notes 4.5
20-Year Treasury Bonds 7.5

 

Perhaps even more shocking is that during this period, the only year in which the HFRX index outperformed the S&P 500 was 2008. And even worse, when compared with a balanced portfolio allocated 60 percent to the S&P 500 Index and 40 percent to the Barclay's U.S. Government/Credit Bond Index, it managed to underperform every single year.

 

Why Do Investors Still Like Hedge Funds?

A key question, which I addressed in a post last month, is: Why do investors, including institutions, continue to ignore the evidence and pour money into hedge funds? Despite their dismal performance, assets under management at hedge funds continue to grow, now reaching almost $3 trillion.

 

What's particularly puzzling is that we don't see this same trend when we look at the fund flows for actively managed mutual funds. In aggregate, actively managed funds persistently underperform, and investors are taking notice and action.

 

For example, for the 12 months ended August 2014, equity index funds and ETFs attracted $131 billion in net cash inflows. In the same period, actively managed funds suffered outflows of $55 billion. However, perhaps we are seeing the first signs of a turning tide—perhaps a tipping point has been reached.

 

On Sept. 15, 2014, the California Public Employees Retirement System (CalPERS), the largest U.S. public pension fund, announced its decision to completely eliminate its hedge fund investments. The exit included redeeming from 24 large hedge funds and six hedge funds-of-funds investments totaling $4 billion. That's out of a total portfolio of roughly $300 billion. Given the evidence, the only question one might ask is, "What took them so long?"

 

The Significance Of CalPERS' Decision

Here's what Moody's had to say in its Credit Outlook from Sept. 22 2014:

 

"Large institutional investors have been the primary drivers of flows into alternatives such as hedge funds and CalPERS was at the forefront of this movement. CalPERS' action is significant for the industry's growth outlook given the fact that the flow of funds into alternatives has been dominated by large institutional investors. This is in contrast to the early days of the alternatives industry when high-net-worth individuals accounted for the majority of investments. CalPERS started its hedge fund investment program in April 2002. Since 2008, the primary source of funds going into alternatives has been from institutional investors, namely public and private pension plans, endowments and foundations, and sovereign wealth funds (i.e., large, institutional fiduciaries)."

 

Moody's noted that given CalPERS' decision, it's likely that "more alternatives programs will come under scrutiny since hedge funds as a group have underperformed traditional benchmarks. Alternatives have the highest fees and greatest liquidity costs–attributes that are at odds with secular trends toward transparency, liquidity and lower-cost investing. Furthermore, the signaling effect of CalPERS' decision to exit completely is entirely different from one of reducing hedge fund exposure. The question of whether to scale-up or completely exit a hedge fund program is likely to face other plans with similar exposures as CalPERS."

 

Moody's last comment certainly seems prescient in light of the Jan. 9, 2015, announcement from PFZW (Pensioenfonds Zorg en Welzijn), the €156.3 billion Dutch health care workers' fund and Europe's second-biggest pension fund, that it was stopping all further investments in hedge funds.

 

PFZW was one of the first Dutch pension funds to invest in hedge funds back in 2003, and it had close to 3 percent of its assets in them. In announcing the decision, Jan Willem van Oostveen, PFZW's manager for financial and investment policy, stated: "With hedge funds, you're certain of the high costs, but uncertain of the return."

 

Perhaps institutional investors are finally waking up to all the problems with the hedge fund industry.

 

The Problems With Hedge Funds

1. Lack of liquidity: Unlike mutual fund investors, hedge-fund investors typically must accept long lockup periods. In addition, redemption rights can be suspended. Liquidity is a risk for which investors should receive additional compensation. The evidence shows that, with hedge funds, there clearly hasn't been any compensation for this incremental risk.

 

2. Transparency: Because hedge funds lack transparency, investors lose control over their asset allocation, the most important determinant of the risk of a portfolio.

 

3. Non-normal distribution of returns: Hedge funds have characteristics that risk-averse investors dislike, and the majority of investors are risk averse. Hedge funds exhibit both negative skewness (the opposite of a lottery ticket, where most people lose but losses are small and a few winners win big) and high kurtosis. Assets that exhibit high kurtosis produce exceptional returns (both high and low) with greater-than-normal frequency—so-called fat tails."

 

4. Risk of "dying": Studies have found the risk of a hedge fund dying is so great that the median residual lifetime of a fund is just more than five years, and survivorship bias in the reported data on hedge fund returns creates an upward bias of more than 4 percent per year. In just the first half of 2014, 416 hedge funds closed. Were that rate to be mirrored over the second half of last year, it would mean the most closures since 2009, when 1,023 were shuttered.

 

5. Riskiness of the assets: Many hedge funds take on significant risk by investing in both illiquid securities and issues of lower credit quality. And many hedge funds use leverage to try and enhance returns. Thus, the alphas reported by hedge funds are often misleading, as they use inappropriate (less risky) benchmarks.

 

6. Tax inefficiencies: Due to high turnover rates, the average hedge fund produces returns in a tax-inefficient manner.

 

7. Agency risk: The compensation structure of hedge funds is geared so that much of their reward occurs in the form of incentive pay (usually 20 percent of profits). Investors take all the downside risk, but don't participate fully in the upside. Agency risk can occur when a manager approaches the end of a year and has failed to reach the benchmark level above which incentive compensation is paid. This presents a clear conflict of interest in the form of unequal incentives. If the manager takes large risks in an attempt to beat the benchmark and wins, he will receive incentive pay. However, if the manager fails, he loses nothing and still receives the minimum fee. This creates an incentive for the fund manager to take on greater risk in a game of "I Can Win, But I Never Lose." Note that agency risk is reduced if the manager invests significant amounts of their own assets in the fund.

 

8. Biases in the data: When investors look at the performance of hedge funds, they need to be aware that the data can be very misleading. The returns are overstated by biases in the data. These biases include survivorship bias (which is estimated at greater than 4 percent per year) and instant history bias (also known as backfill bias). The study "Hedge Funds: Risk and Return" found that the backfill bias was more than 5 percent per year. There's also another potential bias known as self-selection bias (poorly performing funds choose not to report). Unfortunately, we cannot know how much of a bias that adds to the data.  And we are not yet done. There is one more important and large bias in the data—liquidation bias. This phenomenon occurs because funds that become defunct often fail to report their last returns. A study, titled "A Reality Check on Hedge Funds," estimated this effect resulted in a bias that overestimates returns by 3 percent to as much as 6 percent.

 

The Problem With Agents
The evidence is so compelling that it seems surprising we haven't experienced more departures from hedge funds than have actually occurred. The explanation likely lies in agent issues. External agents—especially consultants, but also the fund's fiduciaries and investment staff—have conflicts of interest.

 

Unfortunately, it's not in the business interest of hedge fund consultants to recommend passive strategies. And much of the work of internal employees involves the selection and monitoring of active strategies.

 

One of our most famous economists, Paul Samuelson, stated: "[A] respect for evidence compels me to incline toward the hypothesis that most portfolio decision makers should go out of business—take up plumbing, teach Greek, or help produce the annual GNP by serving as corporate executives. Even if this advice to drop dead is good advice, it obviously is not counsel that will be eagerly followed. Few people will commit suicide without a push."

 

This insight helps explain why hedge funds have continued to gain assets despite their poor aggregate performance. But perhaps the CalPERS decision is the tipping point that will lead others to take action. As novelist Victor Hugo noted: "There is one thing stronger than all the armies in the world, and that is an idea whose time has come."


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

 

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