FEBRUARY 24, 2016
As hedge funds returns have lagged the S&P500 index for seven straight years, the question arises as to whether or not hedge funds belong in an investment portfolio or earn their high fees. This is the first of three articles that addresses this issue. The present article reviews the narrative arguments presented by the hedge fund industry to rebut criticisms of hedge fund performance. After years of touting hedge funds’ high returns, alpha generation, high Sharpe ratios, downside risk protection and portfolio diversification benefits, the industry has had to scale back on its claims as each of these benefits proved to be vulnerable to changing markets. Many of these benefits, notably downside protection, portfolio diversification and returns, failed to materialize during the 2007-8 credit crisis and its aftermath. It is important to point out that the “industry” includes not only hedge funds and fund of hedge funds, but the many thousands of people who benefit
from hedge funds including service providers (administrators, prime brokers, attorneys, accountants and banks); distributors (includind registered investment advisors, wealth management groups, brokers and banks); and consultants (along with many academics). It is fair to say that these actors control the hedge fund narrative viewed by most investors.
The response of the industry has followed three paths. First, rather than high returns hedge funds are said to provide higher risk adjusted returns or returns over a complete business cycle than other investments. Second, certain strategies are said to offer tail risk (or extreme downside) protection during volatile markets. Finally, Hedge funds were said to provide diversification for portfolios with traditional stock and bond investments.
These paths were spelled out in a recent paper published by AIMA paper entitled “Portfolio Transformers: Examining the Role of Hedge Funds as Substitutes and Diversifiers in an Investor Portfolio.” According to the paper: “Many of the most experienced hedge fund allocators worldwide no longer see hedge funds as a separate bucket − ring-fenced, somehow, from the traditional” assets in a portfolio − but as substitutes for long-only investments and diversifiers capable of transforming the risk and return characteristics of their entire portfolios.”
A recent paper by Lyxor Research entitled “A New Era for Hedge Funds,” points out that: In our investment philosophy, hedge funds can be regarded as (equity or bond) beta providers or pure alpha generators. Intelligent use of beta provider hedge funds allows more efficient risk diversification compared to traditional assets. Moreover, it is worthwhile to introduce some pure alpha generator hedge funds to generate uncorrelated absolute return. Finally, Skybridge Capital, an influential fund of hedge funds, in a subtle document called “Why Investors Should Allocate to Hedge Funds,” (January, 2015) claim that hedge funds offer the following desirable traits: Competitive full market returns; mitigating drawdowns or risk of portfolio loss; reasonably low volatility; and moderate-to-no correlation and beta to other major asset classes. The following columns will evaluate the industry narrative.