Some big names in the financial world have been putting the boot into hedge funds in recent weeks. Warren Buffett scoffed at their "unbelievable" fee structure, a complaint echoed by iconic bond manager Bill Gross ("a giant ripoff").
Even hedge fund managers are critical of their industry colleagues – billionaire investor Steve Cohen complained that "talent is really thin" while Third Point's Dan Loeb warned the industry faces a "washout" after suffering a "catastrophic" quarter. "Catastrophic" might be overstating it. The average hedge fund fell 0.67 per cent in the first quarter.
Nevertheless, frustration is growing among investors, with clients pulling more funds in the first quarter than at any time since 2009. That frustration stems from years of poor returns; only once over the last decade (in 2008) did the HFRX Global Hedge Fund Index outperform the S&P 500.
Mediocre returns have resulted in pension funds coming under pressure to dump their expensive hedge fund investments. Last year, PFZW – Europe’s second-largest public pension fund – did just that, withdrawing its entire €4.2 billion hedge fund investment holding. It was following in the footsteps of Calpers, the largest US pension fund, which ditched its hedge fund investments in 2014.
Hedge funds say some of the criticisms levelled at them are unfair. Hedge funds are meant to hedge, which means they will never be 100 per cent exposed to equities. Consequently, some underperformance is inevitable in a long bull market.
Hedge fund advocates can also point to some research that appears to bolster their argument that they have delivered stellar returns to long-term investors. A 2010 study co-authored by Yale scholar Roger Ibbotson found that hedge funds “added value in both bull and bear markets”, averaging annual returns of 14.26 per cent over the 1995-2009 period.
Another well-known study found that annual returns averaged 12.6 per cent over the 1980-2008 period.
Those returns appear impressive, but they are not the full story. The Ibbotson study noted that returns were inflated by survivorship bias (poorly performing funds that closed during the period were not accounted for) and by backfill bias (this refers to when hedge funds do not report early fund performance to a database, instead choosing to “backfill” the database at a later stage when a successful track record has been established).
Annualised returns slipped to 11.42 per cent when adjusted to account for these biases. Hefty hedge fund fees of 3.79 per cent further reduced annual returns to 7.63 per cent – below that generated by the S&P 500 over the same period.
As for the study examining the 1980-2012 period, it noted that the bulk of hedge funds’ outperformance occurred in their early years, when assets under management (AUM) were tiny relative to today.
The average investor, the study found, would actually have been much better off buying and holding equity indices. The study's title – Higher Risk, Lower Returns: What Hedge Fund Investors Really Earn – makes clear that the authors were far from convinced by the argument for hedge funds.
The latter study is extensively cited by former JPMorgan manager Simon Lack in his 2012 book, The Hedge Fund Mirage. Few investors participated during hedge funds' early glory days, notes Lack, only jumping on board en masse during the Noughties. Unfortunately for them, they got badly hit during the global financial crisis in 2008, when the industry "lost more money than all the profits it had generated during the prior 10 years".
Simon Lack estimates the industry generated profits of $449 billion between 1998 and 2010; however, 84 per cent of this figure, or $379 billion, was salted away in fees and management charges.
Worse, this does not account for the fees charges by funds of hedge funds, used by about a third of hedge-fund investors: they took another 14 per cent, resulting in hedge fund investors being left with a mere 2 per cent of the profits generated by the industry over that period.
Little wonder, perhaps, that hedge funds are often described as a compensation scheme masquerading as an asset class. Warren Buffett, as noted earlier, recently described hedge funds’ 2 and 20 model – a 2 per cent annual management fee coupled with a performance fee totalling 20 percent of profits – as “unbelievable”. Buffett’s two investment managers at Berkshire Hathaway, who each manage approximately $9 billion in assets, would “be getting $180 million each merely for breathing” if the firm employed a similar model, said Buffett.
For all the criticism faced by hedge-fund managers in recent years, however, assets under management have nevertheless almost doubled since 2010, to $2.9 trillion, with Credit Suisse recently estimating that assets under management will top the $3 trillion milestone later this year.
These days, hedge funds tend to market themselves to pension funds and institutional investors as a good option in a low-interest world; safer than stock markets due to their lower exposure to equities, but higher yielding than government and corporate bonds. The problem with this argument is that pension funds can lower their risk via an old-fashioned (and cheap) 60:40 portfolio (60 per cent stocks, 40 per cent bonds).
In every single year over the last decade, US investment adviser Larry Swedroe noted recently, a bog standard 60:40 portfolio outperformed the average hedge fund. The HFRX Global Hedge Fund Index has returned just 0.7 per cent annually during that period, he added, “underperforming every single major equity and bond asset class”.
A 2015 study that looked at US public pension funds' hedge fund investments, All That Glitters is Not Gold, came to a similar conclusion. Hedge fund investments lagged the total fund for almost three-quarters of the years reviewed; despite lagging performance, hedge funds collected $7.1 billion in fees, or 57 US cents for every dollar of net return to the pension fund.
Hedge funds’ diversification benefits were found to be overstated, with 10 of 11 pension funds reviewed demonstrating “significant correlation between hedge fund and total fund performance”. All 11 pension funds analysed “would have performed better having never invested in hedge funds in the first place”, the authors concluded.
While pension funds are increasingly coming under pressure to review their hedge fund holdings, hedge funds remain popular with extremely wealthy individual investors. An 18-month-old report from the US-based Spectrem Group found that 42 per cent of investors with a net worth of over $25 million were invested in hedge funds.
Among those surveyed with a net worth of $125 million, 69 per cent held hedge fund investments.
These are remarkable figures, given that returns have been so disappointing for so long now. However, performance may be only so important to some investors, suggests behavioural finance expert Prof Meir Statman, author of What Investors Really Want.
“Investments express parts of our identity,” writes Statman. Just as some people invest in socially responsible funds in order to feel better about themselves, extremely wealthy investors may be attracted to hedge funds because they are associated with status and prestige.
This status, says investment adviser and Above the Market blogger Robert Seawright, is “fundamental to hedge fund allure”, and hedge fund marketing takes full advantage. “Hedge funds are thus the perfect investment vehicle in the age of Trump,” concludes Seawright, “selling ‘luxury’ to people with no concept of value.”