Nir Kaissar is a Bloomberg Gadfly columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.
Hedge funds have had a tough go of it lately. The HFRI Fund Weighted Composite Index – an equal-weighted index of hedge funds – was down 1.1 percent in 2015, and is down another 2.3 percent through February of this year.
It’s not just your workaday hedge funds that have stumbled – the supernovas are burning less brightly, too. Greenlight Capital was down 20 percent in 2015. Hedge funds at Citadel, Blackstone, and Millenium have seen declines this year. And, well, Bill Ackman and Pershing Square’s Valeant debacle.
Granted, every investment has its ups and downs, but investors who dismiss hedge funds’ recent woes as an ordinary cyclical downturn are missing the larger and more worrisome picture.
For many hedge funds, recent declines are the worst since the financial crisis in 2008 (that event served as a useful scapegoat for hedgies' near-universal slump that year). But this time there isn’t a common culprit for managers to point to; hedge funds’ misfortunes have been blamed on various and sundry factors from central bank surprises to unlucky individual stock picks (see Valeant) to bungled market timing.
Despite their recent poor showing, hedge funds remain immensely popular. According to HFR estimates, hedge funds have exploded over the past two-plus decades from 610 hedge funds managing $38.9 billion in 1990 to over ten thousand hedge funds managing $2.9 trillion in 2015.
Hedge funds’ popularity is easy to explain: They promise the golden goose of stock-like returns coupled with the more sedate experience of bond-like volatility.
Amazingly, the hedge funds that make up the HFRI Fund Weighted Composite Index have collectively delivered the goods to investors since the inception of the index in 1990, notching higher absolute and risk-adjusted returns than both stocks and bonds. The HFRI Index returned 10 percent annually from January 1990 to February 2016, with a standard deviation of 6.8 percent and a Sharpe Ratio of 1.04.
By comparison, the S&P 500 Index returned 9 percent annually over the same period, with a standard deviation of 14.6 percent and a Sharpe Ratio of 0.42. The Barclays U.S. Aggregate Bond Index returned 6.3 percent annually over the same period, with a standard deviation of 3.6 percent and a Sharpe Ratio of 0.92. (Standard deviation reflects the performance volatility of an investment, while the Sharpe Ratio is a gauge of risk-adjusted returns; a lower standard deviation indicates a less bumpy ride, and a higher Sharpe Ratio indicates that investors are more adequately compensated for the volatility they take on.)
But the HFRI Index’s enviable long term performance masks an unflattering trend: The rolling ten-year returns have been in a very significant decline since the launch of the HFRI Index. The HFRI Index returned 18.3 percent annually during its inaugural ten years from 1990 to 1999, and it returned just 3.4 percent annually over the last ten years. Draw a straight downward sloping line between those two numbers and you pretty much have the picture.
This deterioration in performance can’t be pinned on any specific, errant hedge fund strategies. Name your strategy -- equity hedge, event-driven, macro, relative value – all of them have weathered the same steady decline in rolling ten-year returns since 1999.
From that vantage the promise of stock-like returns with bond-like volatility looks as fanciful as it sounds. The HFRI Index lagged the S&P 500 by 3 percent annually and the Barclays Agg by 1.3 percent annually over the last ten years. The Sharpe Ratio of the HFRI Index was 0.38 during that period – a third of the Sharpe Ratio of 1.13 achieved by the Barclays Agg.
So what’s killing the golden goose? In a word: investors. It’s likely not a coincidence that as the number and size of hedge funds have swelled, hedge fund performance has sunk. Hedge funds’ success ultimately hinges on two scarce resources – skilled managers and exploitable market inefficiencies – and there simply isn’t enough of either one to support a $2.9 trillion industry.
Hedge funds don’t suffer from temperamental central banks or errant stock picks or even poor market timing. They suffer from an overabundance of investors. If investors want better hedge fund returns, they should get out of hedge funds because right now the industry's own popularity is killing it.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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