Enthusiasm about the world’s hottest investment vehicle–the hedge fund–has sagged of late, thanks to recent mediocre industry-wide performance and blow-ups at Amaranth Advisors and others. Recently the toast of Wall Street, hedge funds seemed like the answer to investors’ prayers: a way to make big money in any market and diversify any portfolio. Alas, as with other investment tools, there’s no free lunch.
Recent academic research, in fact, suggests that hedge funds are not only riskier than they are commonly thought to be, but provide lower returns and less diversification benefit. The advantages of funds of funds, meanwhile, a convenient (if mind-bogglingly expensive) way for institutions and wealthy individuals to own multiple hedge funds, appear to be similarly overstated.
The conventional story is that after five years of amazing growth, the hedge-fund industry is being slowed by its own growing weight. There is more than $1 trillion in hedge funds today, up from some $40 billion in 1990–and thus too much money chasing too few opportunities. Although this is true, greater scrutiny of past performance has also revealed that the average hedge fund’s returns weren’t all that spectacular to begin with. A handful of funds have posted extraordinary results, and awestruck coverage in the financial press has served as an advertisement for the industry as a whole. But the average fund’s results have been distinctly ordinary.
The major databases of hedge-fund performance suffer from severe report-ing biases, which most researchers believe have significantly overstated the industry’s results. According to a recent study by Profs. William Fung of London Business School and David A. Hsieh of Duke University, for example, the TASS database reports that from 1994 to 2004, the average annual hedge-fund return was an impressive 14.4 percent, after fees. However, after adjusting for “survival bias” (the tendency for underperforming funds to shut down and drop out of the database) and “incubation bias” (hedge-fund managers often launch several funds internally but only market the ones that do well), Fung and Hsieh concluded that the true average performance was only 10.5 percent, close to the return for the S&P 500.
Those numbers, moreover, are pretax. The goal of most hedge funds is to make money now, which means trading at a frantic pace and racking up mountains of short-term capital gains. For large pension funds or endowment funds, which don’t pay taxes, this is not a problem. For taxable investors, however, the rapid trading can create a huge tax load, because taxes on short-term capital gains are much higher than those on long-term capital gains. The big tax bills eviscerate the only returns that matter: after tax.
As hedge-fund returns have declined, proponents have begun emphasizing their diversification benefits. Most hedge funds do not move up and down in tandem with the stock or bond markets, so in theory they can hedge the risk of a diversified portfolio. Here, too, however, recent research suggests that such benefits are overstated. Hedge-fund fans cite the amount by which the funds’ monthly or annual returns vary from their long-term average returns (the standard deviation) as evidence of low risk. And looked at this way, hedge funds do appear to generate solid returns with less-than-average risk. The trouble is, unlike most mutual-fund returns, most hedge-fund returns are not normally distributed, so standard deviation does not provide an accurate picture of risk. Specifically, hedge funds have a greater-than-normal likelihood of generating extreme negative results (no surprise to Amaranth investors).
The same goes for funds of funds. According to Prof. Harry M. Kat of Cass Business School in London, when several hedge funds are combined in a portfolio (as they are in funds of funds), the volatility of the portfolio decreases (good), but the risk of an extreme negative outcome actually increases (bad). As the number of hedge funds in the portfolio increases, moreover, so does the basket’s correlation with the overall stock market. This, in turn, reduces the diversification value of hedge funds.
All of which is to say that, although hedge funds certainly have a place in some portfolios, they are no panacea. You can’t get big returns without taking big risks, and with most hedge funds, only the latter is guaranteed.
