Excess Returns of Hedge Funds Close to Zero

Shirley M. Mueller, M.D.

For years, financial managers have been adding hedge funds to clients' portfolios to pump up returns. What if this only improved manager and hedge fund income and not the clients?

Before I had formal training in the investment industry and I was still practicing medicine, our financial adviser suggested adding a hedge fund to our portfolio. The fund, he said, would diminish risk to our entire holdings and add performance. Additionally, it was a “fund of funds,” meaning it was composed of many hedge funds selected by managers for the ability to add alpha (a measure of performance on a risk-adjusted basis).

When my husband and I pulled out less than a year later, we had lost 25% of our capital in that particular investment. This loss was not only because the hedge fund lost money. It was also because we withdrew within a year which added a penalty, a common policy for hedge funds.

Trying to break out of traditional investing vehicles may be a lost cause.

Now, there is new information on hedge fund performance, which explains in part, our experience. According to Christopher Clifford, Adam Aiken and Jesse Ellis from several different universities, during a five-year period the average excess return of hedge funds was not the 3% to 5% per year that is usually touted, but close to zero. Their paper is entitled “Out of the dark: Hedge fund reporting biases and commercial databases.” It is a working paper online.

The authors analyzed the returns of 1,445 hedge funds registered with the U.S. Securities and Exchange Commission (SEC) 2004-2009. These are funds that disclosed to the SEC willingly since they are not required to do so until March 30, 2012. The total number of hedge funds is up to 10,000.

Of the funds studied, the group that further voluntarily reported their returns to commercial data bases produced an alpha of nearly 1% a quarter. But when the yields of all of the 1,445 funds, including those that did not offer their returns to the commercial database, were included, the alpha dropped to nearly zero. This suggests a serious self-selection bias among hedge funds. Additionally, “dead” funds, those that delisted from the data base, would be expected to make the lack of overall performance of hedge funds even worse. Most reports suggest that 10% to 20% of hedge funds fail each year.

“Leverage and riskier positions could be driving the poor returns of non-reporting hedge funds, which could affect the level of systemic risk present in the financial system,” the authors conclude.

This means that mandatory disclosure to regulatory agencies could be advantageous, not only to those who invest or would potentially invest in hedge funds, but the financial industry in general. If this happens, hedge funds may be like most managed mutual funds that add no or little value to a portfolio.

A Quiz

Question: Why are there so many hedge funds (7,000 to 10,000)?

There is incentive. Typically, the manager(s) take 2% of assets in good and bad years and 20% on top of that when there is a profit.

Answer:

For further reading please see How Moral Hazard Impacts You.

These data suggest that sticking with plain vanilla tactics in investing may be the best strategy. Trying to jump above the crowd could have the reverse effect.