Hedge Funds Trail Vanguard as Elliott Returns Atypical
Before they discovered hedge funds, pension funds and endowments typically held portfolios with 60 percent in equities and 40 percent in bonds. Many would be better off if they had stuck with the old formula.
Hedge funds have trailed both the Standard & Poor’s 500 Index and a Vanguard index fund with the same 60/40 mix over the past five years, according to data compiled by Bloomberg. The balanced fund beat the main Bloomberg hedge-fund index in six of the last seven calendar years, according to data compiled by Bloomberg.
“People hear about the top-performing hedge funds and they assume those results hold true for the whole industry,” George Sauter, chief investment officer for Vanguard Group Inc., said in a telephone interview. “It turns out that on average hedge funds are about average.”
Hedge funds are lagging behind after amassing a record $2.1 trillion in global assets from investors attracted by the returns of top managers such as Paul Singer’s Elliott Management Corp. and Seth Klarman’s Baupost Group LLC. The industry’s underperformance has contributed to an estimated $4 trillion in unfunded liabilities at U.S. pensions and prompted investors such as the California Public Employees’ Retirement System to question whether every manager is worth the standard fees of 2 percent of assets and 20 percent of profits.
While there is no evidence that hedge funds are falling out of favor, their scale is making it more difficult for the hedge- fund industry as a whole to produce better results than other asset classes, said Simon Lack, a former executive at New York- based JPMorgan Chase & Co. (JPM) and author of the 2012 book “The Hedge Fund Mirage” (Wiley, 187 pages, $34.95).
“You have more money chasing fewer opportunities,” Lack said in a telephone interview.
The main Bloomberg hedge fund index, which is weighted by market capitalization and tracks 2,697 funds, fell 2.2 percent a year in the five years ended June 30. The Vanguard Balanced Index Fund (VBINX), which has a 60/40 split of equities and bonds, gained 3.5 percent annually and the S&P 500 Index gained 0.2 percent a year.
The Vanguard fund also beat the HFRX Global Hedge Fund Index, a measure of hedge fund performance with a longer history, every year since 2003.
“People aren’t looking at returns for the past few years and extrapolating,” said Don Steinbrugge, managing partner of Agecroft Partners LLC, a Richmond, Virginia-based firm that advises hedge funds and investors.
Investors still expect hedge funds to outperform in the long run as low bond yields and a slow-growing global economy limit the gains from stocks and bonds, Steinbrugge said in a telephone interview. Hedge funds continue to make sense for investors because over time they have boosted returns and protected investors in difficult markets, he said.
From the end of 2000 through 2002, when the S&P 500 Index fell 17 percent annualized and the Vanguard Balanced Index Fund lost 6.3 percent, hedge funds returned 6.7 percent annually, according to data from Hedge Fund Research Inc.
Hedge funds also beat the balanced fund in 2008, the second quarter of 2010 and the third quarter of 2011, periods when stocks tumbled, data compiled by Bloomberg show. Hedge funds lost 19 percent in 2008 compared with a decline of 37 percent for the S&P 500 Index and 22 percent for the balanced fund.
An April study commissioned by the industry’s trade group found that hedge funds outperformed a mix of stocks and bonds from 1994 to 2011. The HFRI Fund Weighted Composite Index returned 9 percent a year over that period compared with 7.4 percent a year for the balanced fund.
Hedge funds provide investors “with diversification benefits even during the most difficult macroeconomic environments,” according to the report, which was done by the Centre for Hedge Fund Research at Imperial College in London for the Alternative Investment Management Association, the trade group, and KMPG International, an accounting firm.
The study’s results were based on a hedge-fund index that gives equal weight to funds regardless of size, because investors allocate money to funds of different sizes, said Robert Kosowski, one of the study’s authors, in an interview.
Asset-weighted indexes better reflect the actual returns achieved by investors, Lack and Steinbrugge said. Since 1998, HFR’s asset-weighted index trails the performance of its equal- weighted index by about 1.6 percentage points a year.
A May paper on hedge fund performance from 2007 to 2011 written by two researchers at Vanguard came to a different conclusion, saying that many hedge fund categories were “strongly correlated with a 60/40 portfolio of stocks and bonds.”
Vanguard is the largest mutual-fund company, with $1.8 trillion in U.S. mutual-fund assets. The firm popularized index investing and does not offer hedge funds.
Comparing the performance of hedge funds to a balanced fund is fair because 60/40 was the normal portfolio of institutional investors “before they embarked on adding alternatives,” Daniel Wallick, an investment strategist at Valley Forge, Pennsylvania-based Vanguard wrote in an e-mail. Alternative investments include hedge funds, private equity and real estate.
“A diversified hedge-fund portfolio should beat a 60 percent equity 40 percent fixed-income portfolio,” Steinbrugge wrote in an e-mail.
Macro hedge funds, which try to anticipate global economic trends, returned 4.4 percent a year in the five years ended June 30, beating the balanced fund, according to data compiled by Bloomberg. Multi-strategy hedge funds returned 0.9 percent a year over the same stretch. Long-short equity funds, whose managers can bet on rising and falling stocks, lost 2.2 percent annually. Funds that allocate money to other hedge funds lost 2.8 percent.
A 2006 paper written by four academics, including David Hsieh, a professor of finance at the Fuqua School of Business at of Duke University in Durham, North Carolina, found that as more money flowed to hedge funds from 1995 to 2004, the industry’s outperformance or alpha diminished substantially.
Total hedge fund assets reached $2.1 trillion as of March 31, more than four times their level in 2000, and eight times the 1996 total, data from Chicago-based Hedge Fund Research shows.
Hsieh, in an e-mail, said there isn’t enough evidence to show that the lower returns were caused by the growing asset levels. Lower returns, he wrote, “are mostly a function of the markets that the hedge funds are exposed to.”
David Swensen, the chief investment officer of Yale University’s $19.4 billion endowment, said the fees charged by hedge funds are also a drag on their returns. Swensen, speaking at a Bloomberg conference in January, said that hedge funds’ traditional fees of 2 percent of assets and 20 percent of profits “are a huge issue,” and unmerited except for extraordinary performance.
“If you’re going to engage in the game where you’re charging enormous fees, you have to be in the top 5 percent to 10 percent to win on a risk-adjusted basis,” he said.
The best hedge-fund managers have outperformed the S&P 500 Index over long stretches of time. Elliott Management, the $20 billion firm founded by billionaire investor Singer, returned 14 percent a year compared with 11 percent for the index since 1977, according to the firm. The New York-based fund has had nine losing quarters in its 35-year history.
Klarman, founder of Boston-based Baupost, which manages $24 billion, returned 18 percent a year since 1983. The S&P 500 gained about 10 percent annually during that period.
Among investors stuck with a less stellar manager, unhappiness over the mismatch between fees and performance is growing, said Chris Vogt, portfolio manager and global head of hedge funds at Allstate Corp (ALL), a Northbrook, Illinois-based insurer with $1.5 billion invested in hedge funds. Hedge funds on average charge a fee of 1.63 percent of assets plus 18 percent of profits, according to HFR data.
“There is going to be more and more pressure on those who haven’t consistently performed,” Vogt said in a telephone interview. “If we have another flat year of performance, fees are going to have to come down even further.”
Joseph Dear, the investment chief of the $238 billion Calpers, the biggest U.S. pension fund, said in May he wasn’t willing to pay hedge-fund managers the standard fee if they don’t beat the market.
Holland Timmins, chief investment officer of the $25 billion Texas Permanent School Fund, said in January the fund’s returns were being “eaten alive” by hedge-fund fees.
Citigroup, in a June report, concluded that “lingering concerns” about recent hedge-fund performance would not stop institutional investors from putting more money into them. The industry could attract an additional $1 trillion by 2016, Citigroup predicted, as public and private pension funds need strong investment returns to meet their long-term obligations.
In the U.S., public pensions faced more than $4 trillion in unfunded liabilities as of October, according to Joshua Rauh of Northwestern University. That gap, along with low interest rates and low equity-market returns, the Citigroup report found, will drive investors to boost contributions to hedge funds.
Lack, the hedge fund critic, said investors should allocate less money to hedge funds, demand lower fees and have more modest expectations for returns.
“The likely outcome is that returns will be disappointing but the industry will grow anyway,” he said.
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