In January this year Simon Lack published a book entitled The Hedge Fund Mirage: The Illusion of Big Money and Why it’s Too Good to be True. The book makes the not unreasonable claim that the popularity of hedge funds, which began in the early 2000s after the crash of the technology bubble, resulted in too much money driving away the return opportunities that existed in the 1990s when hedge funds were less well known and managed far less money. Simon Lack supports this thesis with a calculation that all the money that has ever been invested in hedge funds would have been better off had it been in Treasury Bills.
To arrive at this calculation Lack examines the dollar-weighted, rather than the time weighted return. The time weighted return, which is most commonly used for comparing investment managers to index benchmarks, ignores any impact on gains or losses from investor allocation decisions (as it should). For assume an investor puts $100 in a stock index fund at the beginning of the year and it goes up 25% and then, feeling confident, he decides to add $1000 at the end of the year only to see the market decline by 20% the following year. On a time weighted return he has broken even and matched the index return. However, on a dollar weighted basis he has lost money – the $25 gain on his previous $100 investment plus a $200 loss on the follow on investment of $1000. Similarly, if the return history of hedge funds consists of a period of good returns when the industry was relatively small during the 1990s followed by a decade of mediocre returns once the industry was discovered and funds poured in, then it is reasonable to expect that the average investor would not have enjoyed the strong returns of the 1990s but would have been invested for the weak returns of the 2000s.
There is some controversy over Lack’s allegation. The Alternative Investment Managers Association, a hedge fund industry association, recently published a 24 page rebuttal of the calculation, which only proved how confusing and ambiguous performance comparisons can get. They took issue with Lack’s choice of index (other hedge fund indexes had outperformed the one that Lack used) and the dollar-weighted return calculation. Lack’s conclusions are supported by an earlier academic paper published in the Journal of Financial Economics which found that the average hedge fund investor earned 3.1% annually over the 1995-2008 period compared to a 3.9% return on T-Bills. Whether or not T-Bills outperformed the average hedge fund investor is less important than the undeniable fact that hedge fund returns have declined as the industry has grown.
The economic logic is certainly compelling. A basic belief in capitalism would lead one to believe that whatever market inefficiencies a $100 billion hedge fund industry was able to exploit in the 1990s would be driven away by the deployment of trillions of dollars of capital. Utilizing two commonly used indexes, the HFRI Hedge Fund Index, an equally weighted composite of thousands of hedge funds, and the HFR Fund of Funds Index, an equally weighted composite of Hedge Fund of Funds, one can see the deterioration of alpha (an estimate of the excess return over holding some combination of the S&P 500 and T-Bills) as the industry grew from the tens of billions to reaching a peak of over $2 trillion in 2007.
Does this make hedge funds a bad investment? Not necessarily, but this research does help debunk the idea that hedge funds are an “asset class” where a diversified allocation to dozens of funds can be depended upon to reliably generate sustainable above market returns. Just like there are a few good mutual funds and far more mediocre to bad ones, the same is true for the hedge fund industry. Some of the strategies that helped drive the strong performance of the 1990s, such as merger or convertible arbitrage, can no longer deliver acceptable returns under traditional hedge fund fee arrangements consisting of 1.5%-2.0% management fees plus 20% of the performance without employing excessive amounts of leverage.
Fortunately, the market is responding with lower cost vehicles for these strategies through open-end mutual funds. This represents a natural progression of any market. New innovations initially command premium prices, but competition erodes both the innovative product’s advantage to consumers relative to other alternatives and its ability to generate abnormal profits for its sellers. Just as junk bonds were an exotic, largely unknown investment in the early 1980s that became a commodity retail product a decade later (under the more appealing name of “high yield”), well known and easily duplicated hedge fund strategies are assuming the same commodity status today. This is not to say that these are necessarily bad investments, but expectations should center on an assumption of obtaining a normal, fair compensation for risk assumed along with a tight focus on fees, expenses and operational risk.
We have liked and used the name “alternative beta” to refer to these strategies in order to denote that they generally represent undertaking known risks for a fair level of compensation. The traditional hedge fund structure remains appropriate for less liquid, research intensive and capacity-constrained strategies such as distressed debt or certain segments of the equity markets and these have tended to be the areas where we have concentrated our search for opportunities. At Comstock we do not view hedge funds as an asset allocation choice similar to bonds or stocks where one decides to invest 20% or 30% of a portfolio, rather these are opportunistic strategies where adding a few funds at 2.5%-5.0% positions can potentially add value to a diversified portfolio of stocks, bonds and other assets.