Because hedge funds returns have often lagged the S&P500 index in recent years, three question arise: whether or not hedge funds belong in an investment portfolio; whether they deserve their high fees; and whether they be viewed as a distinct asset class from traditional stocks and bonds. This is the first of two articles that addresses these issues. 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. Some of these supposed benefits, notably downside protection, portfolio diversification and delivery of absolute returns, failed to materialize during the 2007-8 credit crisis and its aftermath, causing a major refashioning of the industry's message.
The hedge fund industry has developed an ever-changing narrative of the benefits of hedge funds when supposed "benefits" failed to materialize. The “industry” here 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 (including 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, media and others.
The response of the industry has followed at least four paths.
These narratives were supported by the following claims made by hedge fund industry members:
“Many of the most experienced hedge fund allocators no longer see hedge funds as a separate bucket but as substitutes for long-only investments and diversifiers capable of transforming the risk and return characteristics of their entire portfolios.”
"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."
About Ezra Zask
Ezra Zask has spent over 30 years in the finance and investment areas, providing research and consulting to investors and investment management companies. He has founded and managed a hedge fund, fund of funds and investment advisory firms, ans held senior positions in hedge funds and investment advisory firms. He has taught at Princeton and Yale graduate schools and written extensively including a best-selling book, All About Hedge Funds, Second Edition (McGraw Hill: 2013)