Ezra Zask, President, Ezra Zask Research Advisors
SEEKING OPPORTUNITIES: Outsourced Research l Investment Management
One of the most controversial questions in the investment world is: why do hedge funds keep gaining assets when their performance over the past decade has been poor compared to stocks or bonds? After all, hedge fund returns have lagged the S&P for the past 7 years; a period that covers a full business cycle.
One way they have accomplished this feat is by changing the definition of “performance” over time to overcome the inability to live up to the preceding definition which stressed high returns. Thus, high return was replaced by downside protection, alpha and, most recently, diversification and risk reduction.
Hedge funds have faced a number of challenges over the past three decades that have led to fundamental changes in their objectives and operations. A short list of these challenges includes the proliferation of hedge funds and hedge fund strategies; the institutionalization of hedge fund investors; economic crises in 1987, 1994, 1998, 2001 and 2008; sustained stock and bond bull market, and increased criticism of hedge fund fees in light of their performance.
As with any evolution, some hedge funds thrived -- at least in terms of increasing assets under management and generating income for their managers --while others either became extinct or are an endangered species. In the course of this evolution, the surviving hedge funds would not be recognized by investors of 20 years ago.
The performance criteria that hedge funds are expected to meet has changed dramatically over the years. We can broadly identify three hedge fund performance regimes.
In broad strokes, Hedge Fund 1.0, which was dominant in the 1980’s and 1990’s, touted the outsized return that were available through hedge fund investments. George Soros and Julian Robertson were the models for these managers. However, as the hedge fund field became crowded, hedge funds were forced to compete in well-arbitraged markets and these outsized returns became more and more rare. The process was accelerated by the larger scale of funds who were unable to meaningfully invest in small markets.
Hedge Fund 2.0 focused on the downside protection and absolute return measure of hedge fund performance as a result of their relatively small losses compared to other investments during the Asian crisis of 1998, and the Internet bubble of 2001. This hedge fund meme exploded during the Credit Crisis in 2008 when hedge funds as a group lost over 20%. (While still lower than the S&P loss of over 40%, the loss was not supposed to occur under hedge fund 2.0)
Hedge fund 2.0 also included the notion that hedge funds added the elusive and much sought after investment alpha (returns above market returns) which ostensibly resulted from manager skill or unexploited market opportunities. This alleged benefit was also whittled away as new sources of beta were identified (specific to hedge fund strategies and markets) and reduced the size of available alpha.
In hedge fund 3.0 performance no longer holds hedge funds to a benchmark or, indeed, any return criteria. The performance criteria of hedge fund 3.0 is summarized in a paper published by the Alternative Investment Management Association (AIMA), a hedge fund industry group, and the Chartered Alternative Investment Association (CAIA), which provides certification for alternative investments. The paper is titled “Portfolio Transformers: Examining the Role of Hedge Funds and Diversifiers in an Investor Portfolio.” In the paper, hedge funds are touted as either portfolio diversifiers or investment substitutes (for traditional stocks and bonds). The benefits for investors from including hedge funds in their portfolios include the following:
According to the study, hedge fund strategies should reduce the overall volatility (i.e. reduce the risk) of the portfolio’s public markets allocation, with a more attractive risk/reward profile. Other hedge fund strategies may have a low correlation to equity and credit markets and offer a higher probability of generating out-sized returns (albeit by taking on a higher level of risk).
In theory, employing this approach (where hedge funds take on the role of a substitute or complement the equity or fixed income portfolio) offers an investor a way of reducing the volatility (risk) within their public equity allocation, with little if any reduction in the portfolio’s total performance.
One of the interesting aspects of Hedge Funds 3.0 is that performance defined as beating a benchmark (whether S&P or any other benchmark) is no longer required for a hedge fund to be successful. The most that is held out to investors is that hedge funds “offer a higher probability of generating-outsized returns (albeit by taking on a higher level or risk,” which is true of any risky investment.) The second crumb offered to investors is that diversification via hedge funds results in “little if any reduction in the portfolio’s total performance.”
Both of these measures of “success” may come back to haunt hedge funds because it places them squarely in competition with other “substitutes” and “diversifiers” such as smart beta, commodities, and index funds.