There has been a lot of talk in the financial media about hedge funds recently. The discussion has not been characterized by glowing optimism. The media’s primary complaint — that average hedge funds don’t add enough value to justify their fees — is legitimate. We’ve been saying this for years. But it’s not true for the reasons that most media critics give. And it’s not universally true: Sophisticated and careful investors can create portfolios of hedge funds that add substantial value.
Much of the criticism stems from a comparison of nominal hedge fund returns with equity market returns. This misses the point. Nobody buys ten-year U.S. government bonds with 2 percent yields because they love the expected returns; they buy them to diversify their portfolios. For this reason, bond investors aren’t criticized for failing to keep up with equity markets. Similarly, hedge fund investments make sense only if they add value to a broader portfolio. Sophisticated hedge fund investors call that added value alpha: skill-based returns that don’t depend on passive market exposures to other asset classes.
Why are hedge funds subjected to this odd comparison with equities? Mostly because benchmarking them isn’t easy. Individual hedge funds differ widely, and the industry just isn’t that tightly correlated with any single asset class.
Luckily, introductory finance classes offer students a basic tool for finding a more reasonable benchmark for hedge funds. Using a linear regression, an investor can measure the passive return a fund achieves from persistent exposures to equities, credit and fixed income (or whatever mix of risks seems sensible for a given track record). The difference between a fund’s return and the return of this customized benchmark can be thought of as the return attributable to manager skill. A simple approach like this really isn’t enough. It ignores all kinds of information about current market opportunities, manager differentiation and nonlinear risk exposures. But it’s a good start.
When we evaluate hedge funds this way, we learn a couple of things. First, hedge funds as a class aren’t underperforming that much. Second, recent results for average funds still aren’t great. Their alpha has steadily declined over the past decade. Although the average alpha for the HFRI Fund Weighted Composite Index of hedge fund performance was about 5 percent from 2003 to 2007, it has been zero for the past five years. This shouldn’t shock anyone. Alpha is a negative-sum game after fees, frictions and financing. Over the past couple of decades, we’ve seen the development of a much more sophisticated professional investment community and the flow of a lot more money into hedge funds. A more competitive and efficient market is good for the world, but it’s a tougher environment in which to add value as an investment manager.
So should we all just pack up our tents and head back to the land of the 60-40 portfolio? Probably not — or at least, not all of us. Though the average investor will (by definition) buy average hedge funds, more-careful investors can do better. Why? Because the market for hedge funds is still not efficient.
The Efficient Market Hypothesis has various flavors, but the basic idea is that under certain conditions investor decisions will result in efficient prices and the expected return on expertise will be zero. For this mechanism to work properly, the market needs lots of well-informed investors making frequent decisions.
The hedge fund marketplace has relatively few investors, limited and variable access to information, and modest liquidity. Accordingly, expert investors should be able to add substantial value.
How? Smart hedge fund investing requires access to an investment team with the skills, resources and experience to identify attractive opportunities across a wide array of complex strategies, to differentiate among managers with varying levels of skill and to evaluate risk management in normal and shock scenarios. More generally, it requires an organizational culture of accountability for measuring outcomes with sensible benchmarks.
Doing this well is hard, but it’s not impossible, and it is important. The payoff from adding alpha to a portfolio can be very substantial: Raising a portfolio’s annual returns by just 1 percent a year can materially improve ultimate outcomes. To achieve this, investors need to be disciplined about selecting only the best managers. As the data shows, average is no longer good enough.
Benjamin Appen and James Hall are founding partners of New York–based Magnitude Capital. Readers interested in exploring this idea further can do so at www.betterbenchmarking.org, a website developed by Magnitude Capital.
