Do You Need Alternative Investments? Part III: Hedge Funds

I’ve talked before about the tendency of investors to feel like they deserve more than the plain old market return. This seems to be especially true as people build more wealth. Anybody can buy index funds. More sophisticated investments have high minimums, or require you to be an accredited investor. The pinnacle of what I am describing is investing in hedge funds. Hedge funds are exclusive, elite, expensive, and lightly regulated financial products.

There are about 3.3 trillion dollars invested in hedge funds globally, and they continue to grow as an asset class, despite suffering from continued performance that lags a portfolio of low-cost index funds.

The first hedge fund was set up by Alfred W. Jones in 1949. His fund, A.W. Jones & Co, was the first fund to invest in stocks with leverage while using short selling to remove market risk. He structured the fund as a limited partnership to avoid regulation. None of this innovation would have mattered except for one important detail: the fund did really really well. We know that funds that have done well in the past are no more likely to do well in the future, but Jones’ success was publicized in Fortune magazine, and hedge funds were born.

Today there are a lot of different hedge fund strategies. They are typically designed to have performance that is uncorrelated with the market. The Credit Suisse hedge fund index shows that hedge funds have done an okay job at accomplishing this goal. While relatively low correlation with other asset classes can be seen as a good thing in an overall portfolio, the high costs, low returns, and additional risks of owning hedge funds must be considered.

Hedge funds command high fees due to the supposed skill of their managers. They will typically charge 1-2% of the assets under management, plus 20% of any excess performance. In a 2001 study Hedge Fund Performance 1990 - 2000: Do the ‘Money Machines’ Really Add Value Harry M. Kat and Gaurav S. Amin found that the weak relationship between stock returns and hedge fund returns is not attributable to manager skill, but to the general type of strategy that hedge funds follow. Any fund manager following a typical long/short type strategy can be expected to show low systemic exposure to the market, whether he has special skills or not. This leads to the question of why investors would pay such high fees.

The exclusive nature of hedge funds would lead most people to believe that they must also have high returns. This is refuted by the data. The Credit Suisse Hedge Fund Index shows an annualized return of 7.71% from January 1994 through November 2017, while a globally diversified equity index fund portfolio returned 9.19% over the same period. Even a much more conservative index fund portfolio consisting of 60% stocks and 40% bonds outperformed the hedge fund index, returning an average of 7.75%.

Between high fees, lacking evidence of manager skill, and low average returns, hedge funds aren’t sounding so good. Wait until I tell you about the risks.

Hedge funds do not have the same kind of liquidity that an ETF or mutual fund has. Investing in a hedge fund will typically involve a lock-up period during which your funds are not accessible. After the lock-up, hedge funds can suspend investors’ ability to withdraw from the fund at their discretion. That would typically happen at the worst possible time, like if the fund is crashing.

One of the pitches of hedge funds is that they are less risky than stocks, as shown by their relatively low standard deviation of returns. Standard deviation does not tell the whole story. Hedge fund returns exhibit negative skewness and high kurtosis. In plain english, that means that most investors lose while a few winners win big, and the funds exhibit exceptionally high and low returns with greater frequency than would be expected in a normal distribution.

One of the reasons that they seem exotic is that hedge funds can invest in anything. It might be cool to tell people about over dinner, but in reality it means that the riskiness of the underlying assets can be more extreme than you might expect. A 2000 study by AQR Capital Management found that many hedge funds were taking on significantly greater risk than their benchmarks by investing in illiquid assets.

Illiquid assets could result in outperformance due to the illiquidity premium, but investors may have been taking on far more risk than they realized. Hedge funds also employ leverage. The combination of illiquid assets and leverage can be disastrous for hedge funds during bad markets, especially if investors ask for their money back. A worst case scenario would see the hedge fund having to unwind illiquid positions at a significant discount, resulting in losses for investors.

Despite the hype about low correlation, hedge funds are a poor combination with equities. While we know that hedge funds have a somewhat low correlation with the stock market, that correlation can become high at the worst possible times. This is exactly what happened in both the 1998 and 2007 financial crises. So while the correlation data may look good on paper, it may not be very useful in practice.

Even if there are hedge funds out there with great returns, remember that past performance is a terrible predictor of future results. One prolific example of this is the Tiger Fund. It was formed in 1980 with ten million dollars and went on to average returns over 30% for the next 18 years. Wow. By 1998, it had over 22 billion under management, most of that coming from new investments wanting to get in on the performance. Tiger then stumbled badly, losing ten billion dollars, before closing in 2000. The funny thing is that while the fund still shows a 25% average annual return, it is estimated that most investors lost money because they invested after all of the great returns had been earned.

High profile hedge fund failures have not stopped many investors from allocating capital to hedge funds. One of the largest failures, Long Term Capital Management, cost billions of dollars and almost resulted in a global financial crisis. That was in the ‘90s, and hedge funds have continued to grow.

In 2014, CalPERS, a massive California pension fund and one of the leaders in the institutional investment space, made the decision to exit hedge funds as an asset class in their portfolio. They made the decision to shut down their hedge fund program primarily due to the program's cost, complexity, and risk. Other large pension funds have since followed suit.

Eugene Fama, Nobel Prize winner and the father of modern finance, said “I can’t figure out why anyone invests in active management, so asking me about hedge funds is just an extreme version of the same question. Since I think everything is appropriately priced, my advice would be to avoid high fees. So you can forget about hedge funds.”

Warren Buffett famously won a 10-year million dollar bet against a hedge fund manager who was allowed to select five hedge funds to beat the S&P 500 index. The index won out easily. Buffet can’t predict the future, but the odds were certainly in his favour.