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 So finds a new study by Mikhail Tupitsyn and Paul Lajbcygier of
Monash University in Australia, who looked at the evidence of 5,580
hedge funds, about half active and half now closed, between 1994 and
2010.
“The question at the heart of this study is simple: do most hedge
fund managers generate returns through managerial skill? The answer,
according to our work, is no. We show that most hedge fund managers
are passive, not active,” they wrote.
“The majority of hedge funds exhibit linear 'alternative beta' (i.e.
buy-and-hold) strategies ... Over the long run, we can be confident
that the risk exposures of the majority of hedge funds are linear
and aligned with the simple 'buy and hold' exposures of alternative
beta portfolios.”
Obviously, some defining of terms is in order here.
By passive, the authors aren’t suggesting that hedge funds are
stealthily replicating the S&P 500 or some other index and then
trousering fat fees. Rather that they are not fulfilling the promise
of hedge funds as an alternative, instead producing pedestrian
results, which mostly can’t be attributed to exceptional skill.
In this context a linear return would be what you might get out of
the index, or beta as it is sometimes called, while a non-linear
return is something not correlated with the index.
Alternative beta are strategies which attempt to replicate hedge
fund risk/return results at a lower cost.
The authors argue that hedge fund investing is “justifiable” if two
conditions are met: they do stuff average investors could not, and
they generate extra value by so doing.
On those criteria, at least to judge by this study, hedge funds,
well most of them, aren’t justifying the cost of admission.
The study found that just one in five funds produced non-linear
exposure to the wide variety of “factors”, or return drivers, which
were analyzed. As the ability to generate a return that’s
independent of what is happening in the market is a measure of
skill, this undermines arguments for the value of hedge funds.
Arbitrage, event-driven, and managed future fund styles proved the
most likely to be generating non-linear risk exposures, the study
showed.
To be sure, this doesn’t mean that hedge funds are just taking a
buy-and-hold approach. We simply can’t know based on this study. It
is also true that earlier studies have found conflicting evidence of
skill-driven returns among hedge funds.
BETTER OFF PASSIVE?
The question of whether hedge funds are generating returns that
don’t have a linear relationship with the underlying market forces
is not the end of the story. Unfortunately, the study found that the
smaller group of hedge funds which are generating non-linear returns
is actually getting beaten by those which are, more or less,
expensive closet index funds.
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There was also a marked tendency among those funds which showed
skill to drift toward a more passive profile over time. Just 15 to
25 percent of those who did show skill stayed that way, with the
remainder moving toward the pack.
Those skilled funds also demonstrated higher risk of large losses.
While the study did not prove this, it seems possible that hedge
funds start out taking considerable and genuinely non-linear risks
in an effort to distinguish themselves and win clients. That would
explain the risk of large losses.
Once money has flowed into the fund, trimming the sails might seem
prudent, even if it isn’t what clients think they are paying for.
That results in the drift toward the passive category. Interesting
too that linear, or passive, funds have a higher chance of staying
that way than skilled ones of becoming passive.
“While in the short term hedge funds may engage in dynamic trading
strategies involving complex securities, over the long run many of
them behave like alternative beta portfolios,” the authors write.
Many industry advocates will doubtless argue that hedge funds aren’t
an asset class, and that further, the issue isn’t buying a typical
one but one that actually does outperform.
Those arguments are true, but don't change the implications of the
findings.
The odds of finding a good hedge fund which stays that way look
stacked against the investor.
(At the time of publication James Saft did not own any
directinvestments in securities mentioned in this article. He may
bean owner indirectly as an investor in a fund. You can email himat
jamessaft@jamessaft.com and find more columns at http://blogs.reuters.com/james-saft)
(Editing by James Dalgleish)
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