Hedge Funds—Facts Versus Hype: What the Data Shows
By James Parkyn - PWL Capital - Montreal
Studies reveal high fees, lack of transparency and limited diversification benefits
High-net worth Canadians are often approached by advisors trying to sell them on alternative investments such as hedge funds. Such investments are usually promoted as a way to increase returns and reduce the volatility of a portfolio.
It may sound interesting at first blush, but what does the evidence say? Data on hedge funds suggests investors should exercise extreme caution and skepticism, according to Raymond Kerzerho, PWL’s Senior Researcher.
Raymond wrote a detailed three-part series about hedge funds for the CFA Institute’s prestigious “Enterprising Investor” blog in February and March. Raymond reviewed numerous studies about hedge funds for the series. His conclusion: Stay away.
“A black box”
Raymond’s article headings reveal some of the reasons for caution: “The returns aren’t great,” “The diversification benefits are limited,” “The fees are way too high.”
Another concern, Raymond reported, is that hedge funds tend to have complex, hard-to-understand fees and to be opaque about their investing strategies. This makes it harder for clients to gauge the benefits and costs of investing. “It’s what we call a black box,” Raymond says.
For our podcast episode #73, Raymond sat down to discuss his findings. Here are the main takeaways.
What is a hedge fund?
Hedge funds are investment pools that typically promise high returns in any market environment. They use complex and often aggressive strategies to achieve returns that they generally tout as being uncorrelated with traditional asset classes. The funds promote the idea that such uncorrelated returns can offer diversification benefits to a portfolio.
Hedge funds are usually accessible only to institutions and accredited (high-income) investors. In 2019, they managed USD $6 trillion in assets (compared to USD $69 trillion under management by mutual funds worldwide).
How do hedge funds work?
Various hedge funds use dozens of strategies to try to achieve their returns. These can include use of leverage (borrowed money), derivatives (futures and options) and short selling (a strategy to profit when an asset declines in price).
Most of the strategies can be grouped into three categories.
Relative value—This strategy combines long and short positions in highly correlated stocks. For example, a fund may buy shares of a bank while selling short shares of a different bank. The idea is to profit off price discrepancies and reduce risk.
Event driven—Some hedge funds focus on taking advantage of events, such as merger announcements. They may, for example, take a long position in the stock of the target company, while shorting the acquirer.
Directional—This strategy involves taking a bet on stocks, commodities, currencies or other assets.
Do hedge funds deliver the claimed benefits?
Hedge funds generally offer mediocre returns, according to the research. One study in the Journal of Financial Economics found that hedge fund investors had annualized dollar-weighted returns that were 3% to 7% lower than corresponding buy-and-hold fund returns, largely because of poor timing of investors’ inflows and outflows.
“The real alpha of hedge fund investors is close to zero. In absolute terms, dollar-weighted returns are reliably lower than the return on the Standard & Poor's (S&P) 500 index,” the study said.
Hedge funds may also offer less diversification than expected. A paper in the Financial Analysts Journal estimated that the correlation between the Hedge Fund Research Weighted Composite Index and the S&P 500 Index was 0.89 from 2010 to 2020.
The best hedge funds can generate excess return and diversification, but high fees absorb a significant part of the excess returns of even these funds. Holding several hedge funds amplifies the impact of performance fees. One study found that managers may end up with as much as 64% of the gross profit in a diversified portfolio of hedge funds.
It’s also very difficult to predict which hedge funds will deliver superior results. The data shows that there is limited “persistence” in hedge fund returns. In other words, there’s little evidence that a hedge fund which has performed well in the past will keep doing so in future.
How do hedge fund fees work?
A typical hedge fund charges a base fee and a performance fee. The base fee can be 1.5 to 2% of assets, while the performance fee may be 20% of the profit of the hedge fund.
In the past, many hedge funds had what was called a “hurdle rate”—a certain threshold of profit that the hedge fund had to earn (for example, the T-bill rate of return) before it started to charge the performance fee. Today, the vast majority of hedge funds—86%—do not have a contractual hurdle rate for performance fees.
Many hedge funds also have a high watermark. This is a level of the fund’s net asset value above which the hedge fund is allowed to charge performance fees. The idea of the high watermark is that the fund can levy performance fees only on new profits. If the fund loses value, it can’t charge performance fees until it has returned to the high watermark.
But one third of hedge funds don’t have a high watermark. This means they can charge performance fees even if their net asset value has fallen.
How transparent are hedge funds?
Hedge funds have a lot of discretion about what they disclose. They’re generally reluctant to reveal much about their investing strategies, claiming they don’t want to reveal competitive information.
This lack of transparency is a red flag. “Financial firms can make complex products look attractive by exploiting investors’ cognitive biases,” Raymond notes. “As economist John Cochrane once said: ‘The financial industry is a marketing industry, 100%.’ Investors beware.”
As Raymond elaborated in the podcast, “When you’re talking about an advisor working for the product manufacturer, I wouldn’t call that an advisor. I would call them a salesperson.”
What’s the final verdict on hedge funds?
Think twice about hedge funds. “I think if you’re not a multi-billion-dollar institution, the chances of improving your financial outcome with hedge funds are very close to zero,” Raymond says.
His advice is to stay focused on a long-term investing strategy with low fees and transparent holdings. “I generally recommend sticking to stocks and bonds,” Raymond writes. “Financial success depends on disciplined saving and investing, not fancy investment products and high returns.”
Read more commentary and insights on personal finance and investing in our past blog posts, eBooks and podcast on the website of PWL Capital’s Parkyn-Doyon La Rochelle team and on our Capital Topics website.
Find the three-part series about hedge funds that PWL Senior Researcher Raymond Kerzerho wrote for the CFA Institute here, here and here.