AIMA hits back on hedge fund performance criticism
Comparing hedge fund performance with that of the S&P 500 is misguided, according to a new paper published by the Alternative Investment Management Association (AIMA), the hedge fund industry body.
The paper – “Apples and apples: How to better understand hedge fund performance” – advises investors to look at risk-adjusted returns, which illustrate hedge funds have consistently outperformed the S&P 500, MSCI World and global bonds on a risk-adjusted basis. Hedge funds, for example, had a Sharpe Ratio of 1.28 for the five years leading to the end of 2013, while the S&P 500 was at 0.95 despite the recent equity market rally. The MSCI World stood at 0.68 while the Barclays Global Aggregate ex-USD, which measures bonds, had a Sharpe Ratio of 0.38 over the same time period.
“Put simply, many investors value getting steadier returns with lower volatility over higher returns with much greater volatility. Hedge funds actually have lower volatility not only than equities but also bonds. What that means is that in terms of the risk taken, such as in risk-adjusted terms, the industry continues to outperform,” said Jack Inglis, the newly appointed chief executive officer at AIMA in London.
Hedge funds have faced repeated media criticism for delivering returns well below those of the S&P 500. One AIMA source said the frequent reports in the press comparing hedge fund performance to that of the S&P 500 were overly simplistic. "We are trying to encourage people to look at risk-adjusted returns, to look at strategy-by-strategy returns as well as aggregated industry figures, and to consider the longer-term picture. Hedge funds have outperformed mainstream asset classes over the long-term but they have actually also outperformed equities post-crisis on a risk-adjusted basis,” said the AIMA source.
Investors were also warned that short-term data, such as monthly comparisons, were often misleading, as hedge funds have outperformed the main standalone asset classes over the 10 years leading to the end of 2013. The equity market rally and the perceived underperformance at hedge funds has frustrated some allocators. The AIMA paper said this needed to be put into context. “Comparing equity returns with hedge fund returns during a short-lived equity bull market may be misleading because many hedge fund strategies are designed to protect investments during drawdowns rather than necessarily outperforming during rallies,” read the paper. This was evidenced during the financial crisis when the average hedge fund lost 18.3%, compared to the S&P 500, which was down 37%.
“Many investors will have significant exposure to equities and may turn to alternatives and hedge funds in particular to complement this exposure. Hedge funds are designed to provide diversification and low correlation. Investors accept equities can be higher return, but it comes with the risk of higher volatility. Hedge funds give investors lower volatility exposures,” said the AIMA source.
The paper highlighted hedge funds were diverse and there was no such thing as an average hedge fund. Investors should therefore look at hedge funds on a strategy-specific basis and then compare the returns in that strategy to a relevant benchmark for the investments underpinning that strategy. It stated an “apples for apples” comparison could only be made if an individual hedge fund strategy is judged against its underlying asset class – for example, a long/short equity manager with the S&P 500 or a fixed income fund with the relevant bond index.
The study pointed out there wide-ranging differences between hedge fund indices in terms of the methodology employed to calculate average performance and their underlying constituencies, and said these discrepancies could make it challenging for investors to accurately assess performance. The HFRX and Credit Suisse All Hedge Fund Index are asset weighted, which means larger managers have a greater impact on the performance data calculations, said the AIMA study. Meanwhile, the HFRI is equal weighted whereby each fund has an equally weighted contribution to the index irrespective of size. Investors therefore should be alert to the methodologies employed by the indexes that they reference, added AIMA's paper.
Investors broadly recognise the downside protections they are afforded by hedge funds. A survey by Barclays Prime Services found 54% of institutional investors felt hedge funds either met or exceeded their return expectations. Conversely, a sizeable minority stated the contrary with 51% of funds of hedge funds and 56% of private investors complaining performance was lackluster. The majority of these investors blamed the substandard performance on managers taking too little risk or demonstrating poor market timing. Forty per-cent of investors told the Barclays study that macroeconomic factors were a major factor behind the poor returns and a growing number of allocators felt the hedge fund industry had “grown too large relative to available opportunities.”
While many criticise hedge fund performance, the pressure on fees – historically a 2% management fee and 20% performance fee - has had limited success. True, some smaller managers are offering their investors fee discounts, but the majority of hedge funds are still fairly uncompromising on their fee structures. Despite much talk among investors about a fee clampdown, a Goldman Sachs survey in 2013 found 83% of allocators paid full or non-negotiated fees. Sixty-eight per-cent of pension funds, traditionally the most vocal investor constituent on fees, paid full fees, added the Goldman Sachs study.
AIMA has been forced on the defensive over the past few years amid disappointment in hedge fund performance. In 2012, it entered a public war of words with Simon Lack, a former J.P. Morgan executive and author of The Hedge Fund Mirage, a controversial book which argued the average hedge fund had underperformed risk-free US Treasury bills. The book’s conclusion was flatly dismissed by AIMA who counter-claimed hedge funds had actually posted returns double to that of US Treasury bills. Both parties predictably accused the other of using flawed data and methodologies to reach their respective conclusions.
Irrespective of questionable performance showings, investors are still piling into hedge funds. Investor surveys by the prime brokerage arms at Deutsche Bank and Credit Suisse indicate inflows will continue with hedge fund Assets under Management (AuM) likely to reach new highs. Credit Suisse forecasts global assets could grow by $300 billion to reach $2.8 trillion, while Deutsche Bank predicts it could be as high as $3 trillion. These inflows are being driven by institutional investors which are rapidly piling into the asset class. The Barclays study estimated 60% of new investor capital in 2014 flowing into hedge funds would be derived from institutional investors, of which 45% would come from public and private pension plans.