Hedge Funds’ Returns: An Alternative Investment or An Alternative to Investment? (Part 1: Measuring What?)

by Dr Constantin Gurdgiev, Adjunct Assistant Professor of Finance with Trinity College, Dublin

You may find Part 2: Dealing With Biases here, Part 3: Dealing with Funds and Benchmarks Selection here and Part 4: To higher moments and beyond here.

In recent weeks, major financial media outlets have been covering the relatively poor returns posted by the hedge funds industry during the last year.1

According to the business media analysts, the hedge funds’ ability to retain investors’ interest in their offers is currently not matched by their relative performance, compared to other major asset classes. In words of Bloomberg’s Barry Ritholtz, “despite underperforming by a substantial margin, hedge funds keep attracting more investors and assets under management.” To Ritholtz, this presents the “most fascinating investing paradox”. Yet, as the latest data shows, this paradox is currently slowly being unwound in the markets as scores of hedge funds investors are heading for the exit.2

The problems with the top-level view of the hedge funds driving both the negative assessments of their performance and the volatile nature of in- and out-flows of cash they experience are multiple. To explore some of these, this and two subsequent posts will look deeper into the evidence on hedge funds returns and returns measurement methodologies – a subject close to the core CFA Alternative Investment and Investment Theory modules across all levels of CFA body of knowledge.

What is being valued?

Firstly, hedge funds today represent multiple assets, only loosely groups into a singular asset class.

Hedge funds’ explicit strategies include hundreds of permutations of portfolio holdings involving equities, fixed income, debt, private equity, VC exposures, technical and trading algorithms, and so on. In fact, the mere notion that there exists any singular unifying trait between these funds, other than pursuit of risk-adjusted returns, is most likely absurd.

Take, for example, the sub-class of activist investment strategies funds. A recent study from Germany clearly shows that even within this relatively narrow set of intermediaries, differences in the investment style drive differences in reported returns. The study, authored by Wolfgang Bessler, Wolfgang Drobetz and Julian Holler, found that, on average, activist hedge funds increase shareholder value over the investment horizon.3 “However, more aggressive hedge funds generated only initially higher returns and their outperformance quickly reversed, whereas non-aggressive hedge funds ultimately outperformed their aggressive peers. These findings suggest that aggressive hedge funds attempt to expropriate the target firm’s shareholders by exiting at temporarily increased share prices.” Put differently, aggressive funds over-trade and, as a result, exit their investments too early. Now, give this a thought: during the Global Financial Crisis and the Great Recession, a number of hedge funds took positions in distressed companies. Those that exited these positions booked a relatively significant return on their investment. But those that held their positions longer, on average, can be expected to book an even higher return in the future. While the former funds’ returns can be reflected in current hedge funds aggregate indices, future higher returns of the latter are not. The result, at the aggregate, is that reported hedge funds’ returns for activist funds may be biased to the downside.

Overall, as noted above, there is plenty of heterogeneity within the funds’ even when these are categorised on the basis of similar strategies. In their 2014 paper, Maziar Kazemi and Ergys Islamaj found that within the sub-class of actively trading hedge funds (not to be confused with the activist hedge funds covered in the previously cited study), “a few very active managers outperform the moderately active funds and generate higher returns”.4 The authors concluded that “the most active managers use their skills to manage the riskiness of their portfolios and are, therefore, able to provide higher risk adjusted returns. Finally, we find that compared to the least active managers, the most active managers are less homogeneous”. Again, aggregate hedge funds’ returns indices can under-weight most active performers, because they tend to be smaller and more closely held, and thus less prone to disclose their returns.

Both of the above are examples of evidence that suggests something deeper is amiss when it comes to the aggregate measures of hedge funds performance. Specifically, both papers indicate the role of heterogeneity between funds’ strategies and styles in driving differences in risk and return metrics, and both hint at the biases that can be integrated into the aggregate performance indices.

We shall explore these dimensions of hedge funds performance valuations in subsequent posts.

References

1. Gregory Zuckerman “Hedge Funds Keep Winning Despite Losing“, Wall Street Journal, February 8, 2015, , and Barry Ritholtz “The Most Fascinating Investing Paradox” BloombergView, February 12, 2015, . More current and better nuanced benchmarking for hedge funds performance is provided here

2. See More hedge fund investors head for the exits

3. Bessler, Wolfgang and Drobetz, Wolfgang and Holler, Julian, “The Returns to Hedge Fund Activism in Germany”, January 2015. European Financial Management, Vol. 21, Issue 1, pp. 106-147, 2015

4. Kazemi, Maziar and Islamaj, Ergys, “Returns to Active Management: The Case of Hedge Funds”, August 19, 2014. FRB International Finance Discussion Paper No. 1112

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