Hedge funds disappoint -- again

(MoneyWatch) Considerable academic research demonstrates that there is little to no persistence of performance for actively managed mutual funds. Hedge fund investors only wished they could say the same thing.

The performance of hedge funds has been persistently poor, with 2012 being no exception. The HFRX Global Hedge Fund Index returned just 3.5 percent in 2012. By comparison, the S&P 500 Index returned 16 percent. In fact, there was only one year, 2008, in the past 10 when hedge funds beat the S&P 500. Over the past five years, the S&P 500 returned 1.7 percent per year, producing a cumulative return of 8.6 percent, while the HFRX Index lost 2.9 percent per year, producing a cumulative loss of 13.6 percent.

• Hedge funds lag traditional asset classes
• Who's to blame for Facebook losses?
• Understanding "momentum" in stock returns

Last year's performance was so poor that the HFRX Global Hedge Fund Index not only underperformed stocks, but even the Barclays Government/Credit Bond Index, which returned 4.8 percent. That marked the sixth year out of the past 10 that the HRFX underperformed this bond index.

Even worse is that if we compare the return of the HFRX Global Bond Fund Index to the return of a balanced stock/bond portfolio -- 60 percent S&P 500 Index/40 percent Barclays Government/Credit Bond Index -- 2012 marked 10 straight years of underperformance.

Even more devastating is the performance of a subset of hedge funds called "absolute return" funds. These funds are supposed to get positive returns regardless of what the market is doing. That is the "promise," or at least the idea behind them. Unfortunately, the evidence shows that the only thing absolute about them is that they have delivered absolutely abysmal performance. In fact, the HFRX Absolute Return Index actually produced negative returns in three of the past five years.

The cumulative return for the period 2008-2012 was -18.7 percent, or an annualized loss of 4.1 percent per year. By comparison, the BofA Merrill Lynch One-Year Treasury Index (pretty close to a riskless investment) returned 1.4 percent a year, producing a cumulative gain of 7.3 percent, and never had a year with a negative return. The Barclays Government/Credit Bond Index returned 6.1 percent per year, producing a cumulative return of 34.2 percent, and it too did not experience a single year with a loss. For the 10-year period 2003-2012 the Absolute Return Index returned just 0.7 percent a year, underperforming even riskless one-month Treasury bills, which returned 1.8 percent a year.

Given the poor performance of hedge funds, the real puzzle is why investors keep pouring money into them. The only explanations I can think of are that investors have been dazzled by the marketing pitches of Wall Street and are unaware of the evidence.

Finally, some readers will respond with something along these lines: "Who cares what the average fund does? I only buy the top performers." The only problem is that the academic research demonstrates that, just as with actively managed mutual funds, there's no persistence of outperformance of hedge funds beyond the randomly expected.

That's one reason why funds of hedge funds, which tout their ability to identify the future winners, have done so poorly. The other reason is the high costs the industry charges to deliver such poor results.

[reneCBS]

It is expected that most hedge funds will under-perform the broad market most of the time. The reason is that most of them will hedge out some/most of the systemic market risks. Less risk "usually" derives less compensation.

However, absolute return strategies should consistently outperform the markets when the dislocate as they did in 2008. True absolute return strategies should in fact consistently derive positive, or at least flat returns.

I would categorize the hedge fund universe in the following three subsets:

- Absolute Return (less than 3% of the HF universe)
- Unique Alpha Generators (7%-10% of the universe)
- Contamination (the rest)

Much of the problem stems from (1) the inability to distinguish true absolute return strategies from the hedge fund universe, and (2) the focus on Alpha or the attributes to outperform the market in the evaluation of hedge funds. Much of the industry deploys quantitative analysis of return profiles to screen/evaluate managers. This is doomed to fail because the approach fails to consider: the identification of attributes to suggest a persistence in the return profile, liquidity risk and leverage undertaken to derive the returns, and most importantly the implicit short volatility/gap-risk exposures undertaken by the HF manager.

Absolute return does not dwell on outperforming the markets (Alpha). It rather dwells on allocating capital among an array of ideas that are currently receptive to the market, and having the "discipline" to retrieve all or most of the risk from these ideas when the market is no longer receptive to these ideas.

The above statement deserves a more elaborate discussion that would overextend the scope of this comment. However, the reader can find out more by looking at the following link: http://allaboutalpha.com/blog/2013/01/31/risk-management-versus-risk-mitigation-absolute-return-versus-hedge-funds/

Rene Levesque
www.mountjoycapital.com

Rene has interviewed about 5000 hedge funds since 2004.