How exactly should we benchmark hedge funds? It is obviously unfair to compare them directly to equity indices, as the whole point of hedge funds is to aim for an “absolute” return, not a return relative to gains in the equity market. They will naturally under-perform an S&P 500 tracker in years like 2013 when the stock market shoots straight up.
I drew attention last week to the way hedge fund returns have been left badly behind by long-only equity returns over the five years of the post-crisis relief rally, and this understandably provoked comments that this was an unfair comparison. There are also obviously many methodological problems with creating hedge fund indices. Hedge funds have many different strategies, and they may be particularly prone to “survivorship bias” – those that do not have a good story to tell tend to shut down quietly, and do not tell index compilers about their record.
However, hedge funds do have to accept that their offerings will be used by asset allocators trying to use them to balance against the main asset classes of equities and bonds. On that basis, the following chart, produced by Barclays’ capital solutions group using HFRI indices, is very interesting.
It confirms a basic intuition: hedge funds did very well during the bursting of the dotcom bubble, more than held their own during the subsequent 2002-2007 rally, and have had a far harder time of it in the last five years. Why might this be?
Active investment still has some active defenders, at least in the UK, to judge by the reaction to a recent Long View on the subject. And digging into the reasons for active funds’ persistent problems, it is easy to see why. Despite the claims of the Efficient Market Hypothesis (EMH) that it is impossible to beat the market other than by luck, it appears that an impressive number of managers do achieve the feat.
The problem is that they do not manage to beat the index by enough to be able to pay themselves and still pass on a decent performance to their clients. In other words, to quote Jack Bogle, the founder of Vanguard and the spiritual father of index investing, the case for passive investing rests on the CMH (Cost Matters Hypothesis), not the EMH.
Hedge fund returns should not be compared directly to equity benchmarks. Hedge fund marketers will always say this, and with some reason: hedge fund strategies have a different risk-return profile from equities. Many allocate a lot of money to “short” positions, betting against the market. So it is not necessarily that surprising or damning when equity hedge funds suffer a very bad year compared to the index, as happened last year. That was a big part of my discussion with Hedge Fund Research’s Ken Heinz in the latest Note video:
But it is interesting to look at how hedge fund investors seem to have behaved. And in aggregate, they look a lot like classic retail mutual fund investors, chasing performance and piling in after a good run. Inflows to hedge funds last year were slightly lower than they were in 1993, according to HFR (and obviously far smaller in percentage terms). The great boost to hedge funds’ assets came in the years after the dotcom crash of 2000, when many funds managed to rise.