Holding Hedge Funds' Feet to the Fire

As investment products go, hedge funds have to be considered a big success.  Today over 10,000 funds manage an estimated $2.8 trillion in assets, a level that has tripled since 2004 alone. Ironically, this growth has taken place in the face of rather lack-luster performance results. For the sixth consecutive year, hedge funds failed to outperform the broad U.S. stock market in 2014. So what accounts for their continued popularity?

First, some definitions. Hedge funds, much like mutual funds, allow investors to pool their dollars for investment purposes. They are not publicly traded, are less regulated than mutual funds and can employ a wide range of strategies. The higher level of risk inherent in many of these strategies means that hedge funds are only allowed to solicit funds from institutional and high net worth investors.

When first developed back in the 1940s, hedge funds were meant to provide protection or a “hedge” against stock market volatility. By betting against (shorting) stocks, hedge fund managers hoped to protect client assets from market declines. This return objective evolved over the years, however, as highly compensated portfolio managers promised market beating returns in an effort to attract assets. Today, hedge fund managers employ a wide range of strategies to meet a diverse set of objectives. In addition to the traditional long-short investment approach, these range from placing bets on macroeconomic developments to using leveraged funds to exploit security pricing differences. Activist investing, the tactic du jour, involves purchasing big stock positions in individual firms to influence management strategy. 

Hedge funds have several strikes against them when it comes to performance. The standard compensation structure provides managers with a 2% annual fee plus 20% of any profits. Consistently producing 2% excess returns each year is a tall order for any manager. The large volume of assets flowing into hedge funds too means that more and more dollars are pursuing the same strategies. The resulting intense competition reduces security mispricing and opportunities for excess return. Investors tempted to participate in the sector need to develop a solid understanding of what they are buying and at what price, a difficult task given the industry’s tendency toward limited disclosure. 

Defenders of hedge funds are quick to remind investors that their original purpose was not to outperform stocks but to produce absolute return (i.e., positive return in both up and down markets). Unfortunately, after six up years, it is difficult to tell how hedge funds as a group perform in down markets. This is especially true given the number of new managers coming into the market. In the most recent down year (2008) when stocks fell almost 40%, hedge funds on average declined closer to 20%. While less of a loss, this result was hardly the positive performance many investors expected.

The popularity of hedge funds is understandable.  Investors are either attracted to the possibility of outsized returns in these funds or to the opposite, that hedge funds will protect them in a downturn.  But the evidence of hedge funds’ ability to deliver on these objectives is not encouraging.  Consider that a portfolio 60% invested in stocks and 40% invested in sovereign bonds outperformed hedge funds after fees over the last decade.  Sometimes simple really is best.