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Hedge Funds Keep Great Returns for Themselves

Hedge funds command hefty fees because they claim they earn above average risk-adjusted returns, and that the returns generated by their trading strategies aren't easily replicated by lower cost alternatives such as passive funds, mutual funds or ETFs.

Unfortunately, investors face significant barriers in evaluating the performance of hedge funds. The only available performance data comes from voluntary reporting to private companies, creating biases in the available data. The authors of the study "Fooling Some of the People All the Time" focused on commodity trading advisors (CTAs), a subset of hedge funds. CTAs are hedge funds registered to trade futures with the Commodity Futures Trading Commission. They control more than $200 billion in assets.

The study covered the period 1994-2007 and 312 funds. The following is a summary of its findings:

  • The average return (net of fees) on CTAs was 12.6 percent, appearing to exceed the return on Treasury bills by 8.6 percent per year. However, correcting for survivorship bias and backfill bias lowers the average return to CTAs by 7.7 percent to 4.9 percent per year, only 85 basis points above the return to Treasury bills. Thus, while the CTA managers demonstrated the ability to generate alpha, the alpha went to the managers, not the investors. Since alpha is the scarce resource (not investor capital), this is exactly the result that economic theory would predict.
  • To illustrate the impact of biases in the data, surviving funds outperformed the average fund in the database by 3.2 percent (12.6 minus 9.4). There was also a wide difference between the average performance of funds when they report to the database in real time (4.9 percent) and the average performance of all funds including backfill, or instant history (9.4 percent). In addition, the average number of backfilled months is a whopping 43.
  • Even before fees, CTAs display no alpha relative to simple futures strategies that are in the public domain. CTAs report in surveys that they're trend followers and momentum traders. In a survey in 2000, 75 percent of CTAs responded that they are trend followers and 71 percent responded that they used momentum as a signal in their trading approach.
  • These findings mirrored the findings of similar studies performed in the 1980s that found that publicly traded commodity funds didn't create positive returns for investors. Therefore, the combined evidence shows 20 years without outperformance.
The overall conclusion is that CTAs have failed to deliver alpha. The poor performance track record of CTAs raises the question of why the asset class has continued to grow. It's easy to understand why providers are plentiful. The average fixed fee is 2.15 percent, and the variable fee averages 19.5 percent. The result is that CTAs generate fee income of about 4 percent on assets under management, helping to explain the high rate of entry into a market with high attrition rates.

The authors argue that "CTAs persist as an asset class, despite their poor performance, because they face no market discipline based on credible information. There is no required disclosure as with SEC filings for firms or bank call reports. There is no regulation like that for mutual funds or banks. There are no private institutions that certify the managers' competence (like the American Medical Association for doctors), or that certify their performance (like the Good Housekeeping seal of approval), and, as we have seen, no private repository of credible information for comparison purposes. Further, investors' individual experience of poor performance is not common knowledge. In such a setting, it seems that some people can be fooled all of the time."

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