Investors in hedge funds are likely to be paying for a product more like an index fund than a skill-driven market beater.
So finds a new study by Mikhail Tupitsyn and Paul Lajbcygier of Monash University in Australia, who looked at the evidence of 5,580 hedge funds, about half active and half now closed, between 1994 and 2010.
“The question at the heart of this study is simple: do most hedge fund managers generate returns through managerial skill? The answer, according to our work, is no. We show that most hedge fund managers are passive, not active,” they wrote.
“The majority of hedge funds exhibit linear ‘alternative beta’ (i.e. buy-and-hold) strategies … Over the long run, we can be confident that the risk exposures of the majority of hedge funds are linear and aligned with the simple ‘buy and hold’ exposures of alternative beta portfolios.”
Obviously, some defining of terms is in order here.
By passive, the authors aren’t suggesting that hedge funds are stealthily replicating the S&P 500 or some other index and then trousering fat fees. Rather that they are not fulfilling the promise of hedge funds as an alternative, instead producing pedestrian results, which mostly can’t be attributed to exceptional skill.
In this context a linear return would be what you might get out of the index, or beta as it is sometimes called, while a non-linear return is something not correlated with the index.
Alternative beta are strategies which attempt to replicate hedge fund risk/return results at a lower cost.
The authors argue that hedge fund investing is “justifiable” if two conditions are met: they do stuff average investors could not, and they generate extra value by so doing.
On those criteria, at least to judge by this study, hedge funds, well most of them, aren’t justifying the cost of admission.
The study found that just one in five funds produced non-linear exposure to the wide variety of “factors”, or return drivers, which were analyzed. As the ability to generate a return that’s independent of what is happening in the market is a measure of skill, this undermines arguments for the value of hedge funds.
Arbitrage, event-driven, and managed future fund styles proved the most likely to be generating non-linear risk exposures, the study showed.
To be sure, this doesn’t mean that hedge funds are just taking a buy-and-hold approach. We simply can’t know based on this study. It is also true that earlier studies have found conflicting evidence of skill-driven returns among hedge funds.
Better off passive?
The question of whether hedge funds are generating returns that don’t have a linear relationship with the underlying market forces is not the end of the story. Unfortunately, the study found that the smaller group of hedge funds which are generating non-linear returns is actually getting beaten by those which are, more or less, expensive closet index funds.
There was also a marked tendency among those funds which showed skill to drift towards a more passive profile over time. Just 15% to 25% of those who did show skill stayed that way, with the remainder moving towards the pack.
Those skilled funds also demonstrated higher risk of large losses. While the study did not prove this, it seems possible that hedge funds start out taking considerable and genuinely non-linear risks in an effort to distinguish themselves and win clients. That would explain the risk of large losses.
Once money has flowed into the fund, trimming the sails might seem prudent, even if it isn’t what clients think they are paying for. That results in the drift towards the passive category. Interesting too that linear, or passive, funds have a higher chance of staying that way than skilled ones of becoming passive.
“While in the short term hedge funds may engage in dynamic trading strategies involving complex securities, over the long run many of them behave like alternative beta portfolios,” the authors write.
Many industry advocates will doubtless argue that hedge funds aren’t an asset class, and that further, the issue isn’t buying a typical one but one that actually does outperform.
Those arguments are true, but don’t change the implications of the findings.
The odds of finding a good hedge fund which stays that way look stacked against the investor.
(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)
