Are Hedge Funds Worth the Fees they Charge?
What are Hedge Funds?
Hedge Funds are investment managers who aim to apply more sophisticated strategies than conventional long only managers in order to offer investment returns that are not correlated with the major stock and bond markets. Often, this is achieved by relative value strategies that buy one asset and sell another to bet on the relative, rather than absolute spread.
In the early 2000s hedge fund returns were impressive, allowing them to charge high fees. (A typical fee structure for a hedge fund would be to charge an annual 2% fee on assets managed, plus an additional 20% share in positive performance.) Many hedge fund founders quickly became billionaires.
In recent years, an increasing number of large investors have started to question whether hedge funds are now worth the high fees they charge. Calpers, the largest public pension plan in the US with $375 bn AUM, was one of the first to exit its hedge fund investments in 2014. Since then, many others have followed.
Understanding the hedge fund industry can be complicated, with a significant amount of industry jargon. I put together an app to try to help a would-be hedge fund investor analyze the returns that have been achieved by different types of hedge fund. A typical user might be a trustee of a pension plan or endowment wishing to better understand the hedge fund world. You can find the app here. The data that it's based on comes from indices compiled by hedge-fund data provider EurekaHedge.
Broad Industry Performance
The chart below shows the performance of EurekaHedge's broadest industry index over the past 20 years. As with all EurekaHedge indices, it's set to a base reference of 100 as of 31st December, 1999.
You can see here that if you’d invested $100 in their main index on that date, you’d have $450 today. That’s about a 7.8% average annual return over that period, which seems a good return.
Returns have been positive in all years other than 2008 and the first few months of this year. Further, the standard deviation of monthly returns has been less than 5% in most of the past 20 years.
Thus, hedge funds have generally produced returns significantly greater than the standard deviation of those monthly returns. In fact, this ratio is referred to as the Sharpe Ratio and used as a common benchmark for comparing hedge fund performance. Over the past 20 years, the overall index has frequently achieved Sharpe Ratios of 2.5 or better - although the last 10 years have been more challenging.
However, a decision to invest in a hedge fund is implicitly a decision not to invest in something else, such as the stock market. Hence it makes sense to look not only at the absolute returns provided by the hedge fund industry, but also the relative returns against the stock market. The picture changes considerably.
Relative to the S&P500, hedge funds have shown a continuous negative performance over the past ten years. The chart below shows the annual relative returns.
What stands out in this graph is that the year that showed the largest outperformance was 2009. (This year is also shaping up to be a strong outperformance year.) Looking back at the chart above showing absolute returns, you can see that hedge funds lost 10% in that year. However stocks lost much more than 10% in 2009 and were down over 20% at the end of March this year, hence why hedge funds are relatively outperforming.
So we can get an overall sense for what hedge funds offer. They offer more stable returns than the stock market, and they are defensive in down years. In the first ten years of the dataset, they also offered comparable or better returns, making the case for investing in them very strong. In the last ten years it’s a more nuanced choice: do you value the stability and defensiveness enough to get lower returns?
Returns By Strategy
The analysis so far has looked at a broad index of all types of hedge funds. However, hedge funds pursue many different types of strategy and there's a wide variation in the characteristics of these strategies. Let's look at some of the highlights here. EurekaHedge provides indices for 8 strategy types, and the definitions of each of these are shown in the app as you select them from the drop-down menu. What stands out here?
- Distressed debt is the best performing strategy with a return of 6.1x
- Arbitrage is the weakest at 3.6x. However, it also has the lowest standard deviation of returns, ranging from 1 - 2%. Consequently it achieves better than average Sharpe ratios, often about 4
The highest Sharpe Ratio comes from Fixed Income, which happens to be the second lowest overall return over the period. So again, we’re seeing a theme that hedge funds offer a tradeoff of lower returns but for much less risk.
The lowest Sharpe strategy has been CTA (Commodity Trading Advisors), particularly in the last 10 years.
Perhaps the easiest way to compare strategies is to view them side by side. This chart shows the distribution of returns over the 20-year period by strategy.
You can also view these relative to the S&P500:
Returns by Size
Another way to segment hedge-fund returns is to as whether the size of the fund - measured in terms of the value of assets under management - impacts performance. There is clear variation here.
Small funds have offered the highest median returns over the period of the dataset. This is well-understood in the industry because as funds become larger they have more impact on the market when they put on trades and they can only invest in instruments which have enough liquidity to support the size they need to trade. Smaller firms can be much more nimble and exploit small but attractive opportunities. Not surprisingly, smaller funds are riskier and as a result Sharpe Ratio does not vary very much over the size categories.
So what we’ve seen is that in the first ten years of the dataset the case for investing in hedge funds was strong: they offered less risk than the equity market but gave comparable or better returns. However, since 2010 this has stopped being true - with remarkable consistency. The investors choice is therefore more nuanced: are the lower returns a reasonable trade-off for lower risk? The answer to this will vary depending on the investor and their risk tolerance.
That said, it’s hard to see why “lower returns but somewhat less bad in bad years” would be an offering that should merit very high fees and turn their managers into billionaires. Overall the industry has become less compelling in recent years and careful analysis is required before investing.