Hedge Funds And Higher Returns: Myth And Reality
Do hedge funds really deliver higher returns than other investment vehicles?
Published on 26 October 2017
Hedge funds have the potential to provide investors with very attractive returns. These actively managed funds are subject to a lower degree of government regulation, allowing for greater flexibility and risk-taking during the investment selection process. The hedge fund manager may also opt to use leverage to boost returns. While investing with borrowed money can result in increased profits, it is also a risky strategy that could eat away at a fund’s earnings or even lead to losses.
While many funds are highly profitable, a significant number are not. According to Hedge Fund Research, a provider of hedge fund index information, 222 funds closed down in the second quarter of 2017. Last year, the total number of closures was 1,057.
Passive funds that track a particular index are attracting an increasing level of investor attention. With the stock market touching new highs, large amounts of “smart money” is moving into exchange-traded funds (ETFs).
But that’s not to say that institutional investors and high net worth individuals are losing interest in hedge funds. In the second quarter of 2017, 180 new funds were launched. This was in addition to the 189 funds started in the first three months of the year. The size of the hedge fund industry continues to grow and is currently in excess of US$3 trillion.
But do hedge funds make money for their investors? BarclayHedge, a firm that specialises in alternative investments and hedge fund performance measurement, has prepared this tabulation of returns for the last five years:
These figures are calculated from the data submitted by 5,670 hedge funds to BarclayHedge. Although that is less than half the hedge fund universe (which totals over 10,000 funds), the returns can be considered to provide an approximate representation of what an investor can expect.
BarclayHedge also has hedge fund performance data stretching back to 1997. A quick look at these figures reveals that in recent years, hedge fund profitability has dropped quite sharply:
With thousands of funds to choose from and average returns being fairly low in recent years, is there any way that an investor can identify a fund that is capable of consistently delivering high returns?
Investment decisions in a quantitative or “quant” hedge fund are based on a computer algorithm. Trades are carried out automatically according to a pre-decided strategy. The discretion of the fund manager does not come into play in making the trading decision.
Following a systematic strategy in this manner takes the human element out of the investment decision-making process. If the computer-based investment model is well designed, the result can be high profits and superior fund performance.
In fact, this approach seems to be paying off very well for the hedge funds that have adopted this strategy. The 2017 Hedge Fund 100, a ranking of the world’s 100 largest hedge funds by Institutional Investor’s Alpha, a firm that provides information about the hedge fund industry, confirms this. Of the top six firms on its list, five are quants. They use computer programs to make all or most of their investment decisions.
Bridgewater Associates is at the top of this list. The fund had assets of US$122.3 billion in the beginning of 2017 – marking a 17% increase over the earlier year. AQR Capital Management grew by 48% in the same period with its assets under management (AUM) swelling to US$69.7 billion. The firm’s name reveals its investment strategy. AQR is an acronym for Applied Quantitative Research.
If it seems too good to be true, it probably is. In some instances, this maxim could apply to hedge funds. In 2008, investigations revealed that Bernie Madoff’s hedge fund, Ascot Partners, siphoned off a reported US$20 billion. He ran what was essentially a Ponzi scheme, providing consistently high returns to existing investors by using fresh inflows.
Although the amount that Bernie Madoff stole was US$20 billion, investors complained that they had lost US$65 billion. The difference? US$45 billion were the imaginary returns that were reflected in clients’ account statements.
More recently, a US$1-billion fraud was exposed in December 2016, when New York-based hedge fund, Platinum Partners, could not meet redemption requests from investors. The fund had been making double-digit returns for years. But its aggressive investments in payday lenders and oil resulted in large losses.
For some time, the fund attempted to meet redemption requests by borrowing from the market at high interest rates and paying off old investors with money from new inflows. But that only helped for some time. In December last year, the founder of the fund and six others were arrested.
About ten years ago, Warren Buffett the CEO and chairman of Berkshire Hathaway, announced that he was willing to bet US$1 million that the S&P 500 Index would beat the performance of a portfolio of hedge funds over a decade-long period.
Protégé Partners, an asset management and advisory firm based in New York, accepted the challenge and selected five hedge funds. The names of the five funds have not been disclosed. The bet started on 1 January 2008 and it ends on 31 December this year.
But Protégé Partners has already admitted defeat. CNBC reported in August that the group of hedge funds had made an average return of 22%, while Buffett’s S&P 500 index fund increased in value by 85.4%.
When selecting a hedge fund you should exercise much greater caution than you would if you were buying, say, a mutual fund or an ETF. The lack of regulations around hedge funds and the fact that their investment philosophy can vary very widely can make fund selection a challenging task.
The fact is that for every fund that can provide you with a superior return, there are dozens of duds. Identifying the right fund is every investor’s greatest challenge.