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Hedging on the Case Against Hedge Funds

Clifford Asness is the founding and managing principal of AQR Capital Management LLC in Greenwich, Connecticut, a hedge fund and asset-management firm, and is a frequent commentator on financial markets.
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Opinions of hedge funds always seem to be unhedged and occasionally unhinged. In the distant past, opinions were too positive. The media focused on stories of outsized success. Big winners were lionized. Failures were castigated, but not allowed to spoil the narrative.

Everyone wanted in. Many investors assumed hedge funds offered either very high returns or diversification with modest but consistent returns uncorrelated to the rest of their portfolio. Back then I was one of the early critics arguing that hedge funds, as a group, were too correlated to markets and charged investors too much. I haven’t changed my views. But the pendulum has swung and all you read about today is that hedge funds are a failure and investors are fleeing. What was once right is now being taken too far.

This overreaction has three sources. First, there is a failure to understand how to measure hedge-fund returns. Second, even when properly measured, the last few years have been a mild disappointment and they have given critics enough ammo to build an exaggerated case. Third, this has all occurred amid the backdrop of a raging debate about inequality, with hedge-fund managers being an obvious target. Suddenly, some of those best-known for their credentials as social-justice warriors are now experts in hedge-fund return analysis and portfolio theory. Their verdict, predictably, is plutocratic theft.

Of course, questioning hedge-fund investments is a legitimate exercise. I have expressed my own concerns for more than 15 years and have been, in general, supportive of reevaluating hedge funds. Our insight years ago when we first wrote about hedge-fund returns was that they were too correlated with the overall stock market (not enough hedging was happening!) and that this high correlation was partially hidden from investors by what you might call hedge funds’ imperfect liquidity. Imperfect liquidity means you don’t always get a clean read on what hedge-fund holdings are worth each day, week or month. This could be because hedge funds often hold some assets that are difficult to value or, more cynically, that they are intentionally slow in marking them to market. One great way to look as if you have low risk and low correlation to traditional markets is to select a portfolio that can’t be marked‑to‑market regularly. The volatility and correlation are still there, even if your fund accountant and investors can’t easily see them.

Compared with other studies, our research found that more of hedge-fund return came simply from the stock market going up than from the skill of fund managers (or in the industry parlance, from “alpha”). This led to the conclusion that hedge funds’ high fees were harder to justify than other studies found. This was all back in 2001.

Over the years we added to our critique. Consider the part of hedge-fund returns we couldn't explain with passive stock-market exposure. Some of this may indeed be a result of unique manager skill, but certainly not all. Instead, a fair amount seems to come from relatively straightforward exposure to known strategies such as trend-following, the carry trade in many forms, and broad-based arbitraging of situations like mergers and convertible-bond offerings. Exposure to these strategies is useful and should indeed entail a fee above traditional market-index funds. But these strategies are not what the industry would call “unique alpha” and shouldn’t come with the famous 2 and 20 price tag -- a 2 percent fee on assets under management and 20 percent of any investment gains. (Disclaimer: We’ve built a tidy little business providing these strategies in truly hedged forms with lower than traditional hedge-fund fees, so I’m not a neutral party here.)

For years I hoped that this type of critique would be used not as a reason to forsake hedge funds but to push them to be more investor-friendly, primarily by lowering fees and running more truly hedged portfolios. But what we hear today is based more on hyperbole, bad math and moral denunciation with the recommendation being abandonment.

How do you judge hedge-fund returns? By far the most frequent sound bite used in the recent salvos is that hedge funds have trailed the Standard & Poor’s 500 Index markedly and consistently since the stock market hit bottom in March 2009. It is true that they have lagged behind, but it’s also true that in such a market they should underperform! The average hedge fund has always been, and still tends to be, “net long,” betting that the stock market rises over time. But most hedge funds are still much less long stocks than the typical equity-mutual fund. A fully invested, actively managed equity-mutual fund might expect to rise and fall on average at the same rate as the stock market, hoping to do somewhat better over time. Hedge funds will run far less “net long.” That is they still do some hedging! Over the long haul, broad portfolios of hedge funds tend to move about 35 percent to 40 percent up or down with the stock market. That is, if the stock market suddenly gained or lost 10 percent, you might expect your hedge-fund portfolio to gain or lose about 4 percent from this market move. Of course, the goal of hedge funds is to add some return on top of this. If they can do that (after fees) then it’s not hard to show hedge funds make an investment portfolio better over the long term, no matter whether they beat the S&P 500.

Obviously, if the market goes up a lot the broad universe of hedge funds will likely lose to it. By the same token, if the market crashes it would be shocking if hedge funds crashed as much. There is an old saying: “Don’t mistake a bull market for brains.” There should be a corollary applicable to hedged investments, even if only partially hedged: “Don’t mistake a bull market for buffoonery.”

This esoteric issue has mattered a lot these past seven years. We’ve had a gigantic bull market since the beginning of 2009. A simple comparison of hedge-fund returns (using the same indexes as the critics) shows the S&P 500 trouncing hedge funds during this period. This is by far the most commonly quoted metric by those on the attack (one version is getting excited that Warren Buffett is winning his S&P 500 vs. hedge fund bet!). But it’s just silly as a critique. Hedge funds should be compared to the 35 percent to 40 percent of the S&P 500 to which they are exposed on average. Indeed, since 2009, against this more appropriate benchmark it’s a virtual tie (and, using the same indexes used by the critics, a victory for hedge funds over the longer term). Some recognize this problem and suggest instead comparing hedge funds to a traditional 60/40 portfolio of stocks and bonds; that’s better, but a 60/40 portfolio still owns way more stocks than is implicitly owned by hedge funds.

Many, even most, of the critics come to wrong and distorted conclusions based on these improper comparisons. Although recent returns are far from hedge funds’ best results, they are also not the disaster often proclaimed.

To be sure, there are things to worry about in hedge-fund land. First, my long-standing critiques -- that hedge funds need to hedge more and charge less -- still apply. Second, this problem has grown as hedge funds have become more correlated with traditional markets, which is of great concern today given the likelihood that traditional asset classes now offer a lower long-term expected return than usual. Third, hedge-fund performance, even when compared to the right amount of stock-market exposure, has retreated in the past few years. Fourth, although managers can’t fully control their returns, they have more control over how much risk they take. There is evidence that hedge funds as an industry are less aggressive than they used to be. This could be a sign that the value proposition is weakening as hedge funds simply do less (the equivalent of closet indexing in a long-only world). Perhaps this means that they manage too much money.

Then again, one of the truisms of markets seems to be that investors and pundits overreact. Only time will tell if the hostility to hedge funds is an accurate harbinger of tougher times to come or the typical knee-jerk reaction that comes with any period of below-norm performance.

By charging so much, sometimes for fairly simple and known strategies, hedge-fund managers set expectations too high and gain no slack for the inevitable tough times all investments face. They are learning that now. I hope that investors will sift through the overblown case against hedge funds and use this moment to exhort the industry to become better by charging less, hedging more and providing real diversification.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Clifford Scott Asness at asnessc@bloomberg.net

To contact the editor responsible for this story:
James Greiff at jgreiff@bloomberg.net