Why hedge funds are like the undead

Market Analyze CBS/iStockphoto

(MoneyWatch) While reviewing the latest round of papers and articles on hedge funds, I was reminded of the film "Night of the Living Dead" -- no matter how many zombies were killed, more kept coming back. In 2008, about 1,500 funds were liquidated and 500 launched. The next year, about 1,000 were liquidated, and more than 500 new ones launched.

The risk of a hedge fund dying (shutting down) is so great that a 2005 study, "Hedge Funds: Risk and Return," by Burton G. Malkiel and Atanu Saha, found that survivorship bias in the reported data on hedge fund returns creates an incredibly large upward bias of 4.4 percent per year. The same study found that less than 25 percent of the funds in existence in 1996 were still alive in 2004! The difference in returns between the live and defunct funds exceeded 8 percent per year (13.7 versus 5.4). Think about the survivorship bias that difference can create. And a 2002 study, "Hedge Fund Survival Lifetimes," covering the period from 1990 to 2001 found that the median residual lifetime of a fund is just 5.5 years.

Perhaps hedge funds should come with their own "life insurance" policies.

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Making matters worse is that since the evidence shows that there's no persistence in performance beyond the randomly expected, how are investors to know in advance which fund to choose in order to be at, or above, average? It's like buying a lottery ticket: a small chance of hitting a home run and a much larger chance of hitting into a double play. Yet money keeps pouring in. As of the second quarter of 2011, the hedge fund industry is estimated to have more than $1.9 trillion in assets under management, with perhaps as many as 8,000 funds in operation.

The many studies on the performance of hedge funds show that once risks (illiquidity, leverage, small and value, credit, term, and so on) and biases (survivorship, self-reporting, liquidation) are accounted for, there is no persistence of outperformance beyond the randomly expected. Furthermore, if pre-expense outperformance is in fact generated, it's typically more than consumed by the fees.

Among the reasons for lack of persistence, even with skillful hedge fund managers, is that cash flows to past winners and overwhelms their ability to generate outperformance. Another is that the markets are highly efficient. A third is that successful strategies tend to get "crowded" quickly. That leads to the elimination of any anomaly, along with the the problem that when risks crop up, everyone will be trying to get out of the barn at the same time (not a good thing, as many hedge funds invest in illiquid securities), causing market impact costs to soar.

As we have discussed, one appeal of hedge funds seems to be the virtually unlimited discretion managers have to "style drift." But that creates a major problem -- investors lose control over the risk of their portfolio. The "good" news is that Wall Street now has a solution to that problem.

Academic research on hedge funds has found that hedge fund strategies can largely be replicated cheaply. In other words, you don't have to pay 2 and 20 to gain access to risk factors (such as small stocks, value stocks, illiquid securities) or mechanical rules (such as the carry trade, momentum). Instead, you can buy new "index" or "passive" products that attempt to replicate these hedge fund strategies. Among the players bringing these new strategies to the public in the form of ETFs are IndexIQ, WisdomTree, and AdvisorShares. Goldman Sachs (GS) and Credit Suisse (CS) also have ETFs that are hedge fund replicators.

The good news is that these products eliminate the problem of lack of transparency and also provide daily liquidity. In addition, the fees are typically much lower than they are for hedge funds themselves. And they just might provide you with exposure to a unique source of risk and returns, a source that doesn't correlate well with the other assets in your portfolio.

Still, you must be very careful to be sure that you're truly gaining access to a unique driver of returns at a reasonable price, and you must understand how the risk of that investment mixes with the rest of the portfolio. Many hedge fund strategies also can't be replicated by simply applying mechanical rules (such as merger or convertible arbitrage). And of course they can't generate managerial outperformance (if it exists).

The bad news is that the funds are still typically more expensive than other traditional passive choices (such as index funds), and many may simply be a more expensive way to gain exposure to the risk factors that can be accessed through lower-cost vehicles. The usual caution applies: Be careful out there, you're likely to be exploited.

  • Larry Swedroe On Twitter»

    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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