By LARRY SWEDROE
Academic research, including studies such as Mutual Fund Performance: An Empirical Decomposition into Stock-Picking Talent, Style, Transactions Costs, and Expenses and Changes in Ownership Breadth and Capital Market Anomalies, has found that, at least on a gross basis, actively managed mutual funds are able to identify stocks that go on to outperform. Unfortunately, that same body of research has found that the beneficiaries of the alpha-generating skills were the fund sponsors, not the investors—after expenses, mutual funds generated negative alphas. ]
As Andrew Berkin and I demonstrated in our book The Incredible Shrinking Alpha, the publication of academic research (which converts what was once alpha into beta, or a common factor that can be accessed systematically and cheaply), the increasing skill of the competition, the shrinking population of victims (naive retail investors) that can be exploited (as individual investors move toward mutual funds from individual securities), and the increasing supply of dollars chasing that shrinking pool of alpha have made the markets more efficient, making it increasingly difficult for mutual funds to generate alpha. Have hedge funds, with their supposedly superior skills, provided a better experience?
F. Amir-Ghassemi, A. Papanicolaou and M. Perlow contribute to the literature with their study Aggregate Alpha in the Hedge Fund Industry: A Further Look at Best Ideas, published in the February 2022 issue of The Journal of Portfolio Management, in which they examined the stock-picking behaviour of nearly 1,500 hedge funds. They used regulatory mandated position-level data from the SEC (Form 13F) to determine if hedge funds exhibited stock-picking skills that enabled them to identify undervalued securities and generate alpha. Their data sample covered the period 1999-December 2018. They extended their analysis by splitting the time series into two roughly equal periods centered on the global financial crisis (GFC) of 2008. Aggregate reported assets increased by nearly $1.5 trillion in the post-GFC period from 2009 to 2018 (from $680 billion to $2,120 billion) compared to a $360 billion increase from 1999 to 2008 (from $320 billion to $680 billion). The authors also examined the performance over the two periods of the “Best Ideas” (largest holdings) to determine if asset growth negatively impacted returns. Following is a summary of their findings:
Over the full period, on an asset-weighted basis, hedge fund managers generated abnormal returns of 13 basis points (bps) per month using the Fama-French five-factor model (beta, size, value, investment and profitability). The alphas were statistically significant at the 5% confidence level .
The post-GFC period saw a significant decline in gross alpha from the pre-GFC period, from a statistically significant 17 bps per month to a statistically insignificant 5 bps per month.
There was no statistical difference in alpha characteristics between hedge fund Best Ideas and the rest of their portfolio positions—the decline in gross alpha in the post-GFC period was not principally driven by asset gathering.
The finding that the decline in gross alpha in the later period was not principally driven by the growth in assets provides further evidence that the markets are becoming increasingly efficient for the reasons discussed in The Incredible Shrinking Alpha—making it increasingly difficult to generate alpha.
Amir-Ghassemi, Papanicolaou and Perlow’s findings on the stock-selection skills of hedge fund managers are consistent with those of Charles Cao, Yong Chen, William Goetzmann and Bing Liang, authors of the study Hedge Funds and Stock Price Formation, published in the third quarter 2018 issue of the Financial Analysts Journal. They found that hedge funds tend to hold undervalued stocks—stocks that go on to outperform, generating alpha relative to the Fama-French four-factor (beta, size, value and momentum) model. They also found that hedge fund ownership and trades are positively related to the degree of mispricing—hedge funds increase their purchases with the degree of underpricing.
Do investors benefit from the stock-selection skills of hedge funds?
While their stock-selection skills enabled hedge funds to generate statistically significant gross alphas in the pre-GFC period, the only beneficiaries were the fund sponsors—17 bps a month is insufficient to cover the typical fee of 2% plus a performance fee of 20% even before considering the fund’s trading costs. Thus, investors were earning net negative alphas. And while fees have come down somewhat, the evidence shows that the once-statistically-significant alpha has disappeared—even an economically significant 5 bps in gross alpha would not come close to covering a hedge fund’s total expenses.
To further determine if investors benefit from the skills of hedge fund managers, we will review the findings on their performance. Javier Estrada, in his March 2021 paper No Hedge Funds, No Cry, examined the performance of hedge funds over the 10-, 15- and 20-year periods ending in 2020. His sample consisted of the HFRI Composite Index of hedge funds, the S&P 500 Index of U.S. stocks, the Bloomberg Barclays U.S. Aggregate Index of U.S. investment-grade bonds, the MSCI ACWI Index of global stocks, the Bloomberg Barclays Global Aggregate Index of global investment-grade bonds, and gold prices. Following is a summary of his findings using U.S. equities for the comparison with stocks and U.S. bonds in a 60-40 portfolio:
Over the last 10-year period, the annualised return of hedge funds (4.2%) was far lower than that of stocks (13.9%) and a 60-40 strategy (10.0%), albeit with lower annualised volatility (6.1% for hedge funds versus 13.5% for stocks and 8.0% for the 60-40 strategy). They also produced lower risk-adjusted returns than both stocks and the 60-40 strategy (2.0% compared to 3.0% and 3.6%, respectively).
Over the last 15 years, hedge funds underperformed stocks and the 60-40 strategy in terms of return (4.7% versus 9.9% and 8.1%), though they exposed investors to lower volatility (6.6% versus 15.1% and 9.0%). In terms of risk-adjusted return, hedge funds slightly outperformed stocks (2.1% compared to 2.0%) and underperformed the 60-40 strategy (2.7%).
Over the last 20 years, hedge funds again underperformed both stocks and the 60-40 strategy in terms of return (5.5% versus 7.5% and 6.9%) but again exposed investors to lower volatility (6.3% versus 15.1% and 8.8%). Over this period, on a risk-adjusted basis, hedge funds outperformed both stocks and the 60-40 portfolio (2.6% versus 1.6% and 2.3%). Keep in mind that the performance deteriorated as their assets under management increased.
Over the last 10, 15 and 20 years, portfolios with an allocation of 44.8%, 42.9% and 42.3% to stocks matched the volatility of hedge funds and produced higher returns.
Estrada also examined the downside protection provided by hedge funds. Following is a summary of his findings:
Over the worst 12 months during the 20-year period, the average loss was 9.9% for stocks, 5.6% for the 60-40 portfolio and 3.2% for hedge funds. Gold averaged a gain of 1.5%, providing superior downside protection to that of hedge funds.
Over the worst six quarters during the 20-year period, the average loss was 16.8% for stocks, 8.2% for the 60-40 portfolio and 6.9% for hedge funds. Gold averaged a gain of 5.4%, providing superior downside protection.
Over the worst four calendar years during the 20-year period, the average loss was 18.9% for stocks, 8.9% for the 60-40 portfolio and 5.2% for hedge funds. Gold averaged a gain of 7.9%, providing superior downside protection.
Estrada noted that the superior downside protection of gold relative to hedge funds should not have been surprising because, although hedge fund managers typically stress their goal of delivering uncorrelated returns, the correlation between hedge funds and stocks was a very high 0.89, 0.85 and 0.83 over the last 10, 15 and 20 years, respectively. On the other hand, the correlation of gold to stocks was 0.08, 0.06 and 0.04.
International evidence
Estrada also examined the performance using global equities for stocks and for the 60-40 portfolio. Given the very poor performance of international equities over the last 20 years (over the period 2001-2020, while the S&P 500 Index returned 7.5% per annum, the MSCI EAFE Index returned just 5.0%), it is not surprising to see that hedge funds performance looks somewhat better when a global equity portfolio is the benchmark:
For the 10-year period, hedge funds underperformed, producing a risk-adjusted return of 2.0% versus 2.1% for global equities and 2.3% for the global 60-40 portfolio.
For the 15-year period, hedge funds outperformed, providing a risk-adjusted return of 2.1% versus 1.6% for global equities and 1.9% for the global 60-40 portfolio.
For the 20-year period, hedge funds outperformed, producing a risk-adjusted return of 2.6% versus 1.4% for global equities and 1.9% for the global 60-40 portfolio.
Over the last 10, 15 and 20 years, an exposure to global stocks of 31.0%, 24.5% and 23.7%, with the rest in global bonds, would have matched the volatility of hedge funds and produced higher returns.
His findings led Estrada to conclude: “Individual investors do not seem to have much of a reason to cry for lacking access to hedge funds.” He added that his conclusions were unchanged using the asset-weighted returns of hedge funds. It’s important to add that the underperformance of hedge funds is even before accounting for their lack of liquidity (for which investors should require a risk premium) or considering their lack of transparency.
Investor takeaways
While hedge fund managers are highly skilled, the evidence presented demonstrates that skill is not a sufficient condition for investment success. The skill level of the competition (which has been increasing) and costs matter as well. The evidence presented makes it easy to see why David Swensen, the legendary chief investment officer of the Yale Endowment, offered this observation in his book Unconventional Success: A Fundamental Approach to Personal Investment: “In the hedge fund world, as in the whole of the money management industry, consistent, superior, active management constitutes a rare commodity. Assuming that active managers of hedge funds achieve success levels similar to active managers of traditional marketable securities, investors in hedge funds face dramatically higher levels of prospective failure, due to the materially higher levels of fees.” As for funds of hedge funds, Swensen called them “a cancer on the institutional-investor world” and said they “facilitate the flow of ignorant capital.”
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