09 AUGUST 2017 An enormous body of literature touts the benefits of investing in hedge funds. A typical analysis uses aggregate indices published by Hedge Fund Research, Morningstar and others to make their case. Investors can’t invest in hedge fund indices, however, and are thus unable to monetize the purported benefits of hedge funds. Consider an analysis showing that the risk/return profile of a traditional portfolio comprised of stocks and bonds is improved with the addition of the HFR Hedge Fund Index. Investors can’t invest in the HRF Hedge Fund Index. They must invest in one or more of the 5,000 managers that comprise that index. (We leave aside here the data issues that limit the usefulness of these indices). However, selecting the right managers depends on overcoming two crippling obstacles: [...]
However, selecting the right managers depends on overcoming two crippling obstacles: the wide dispersion of hedge fund returns and the lack of sustainability of hedge fund performance.
A. Dispersion of Hedge Fund Returns
David Swensen, the successful Chief Investment Officer of the Yale Endowment, as well as others have pointed out the wide dispersion of manager returns and the importance of selecting top performing managers to attain the benefits imputed to hedge funds. Swensen’s success depends on his ability to identify and invest in top-tier performing funds.
As shown below, however, the dispersion of hedge fund returns is much wider than for stocks and bonds. This is true even for equity hedge funds, which have a lower volatility but a much wider dispersion that stocks. The difference between selecting a manager near the top or bottom of the range will decide whether an investment in hedge funds is beneficial or not.
B. Hitting a Moving Target: Lack of Persistence in Hedge Fund Performance
In addition to selecting top-tier managers, investors need to select funds whose top-tier ranking is persistent over time. ot predict its ranking in subsequent periods. Paradoxically, it turns out that the familiar disclaimer that past performance is not indicative of future performance turns out to be absolutely true.
Goldman Sachs’ article, perhaps ironically called “The Case for Hedge Funds,” reports that a fund’s performance ranking in one period provides very little information about its ranking in subsequent periods. In other words, choosing funds on the basis of their past performance is effectively a random process.
The Goldman Sachs report summarizes the findings as follows:
Assuming that the strong performers of the past will remain at the head of their pack in the future has historically been a mistake, precluding this approach as the primary means to vet managers. For example, looking at data over the period 1990–2012, only 21% of first-quartile performers in one year remained first-quartile performers in the next, as shown above. Conversely, 23% of bottom-quartile performers made the top quartile the next year. (p. 7)
C. A Leap of Faith: It all comes Down to Manager Selection and Portfolio Construction
Reaping the benefits of hedge funds is extremely difficult given their wide dispersion and lack of persistence. Yet manager selection is the key to gaining the benefits of hedge funds. How do investors and their advisors deal with this conundrum?
It is instructive to look at how Goldman Sachs reconciles the report’s rosy picture of hedge fund benefits with the problems of identifying top performing managers:
Manager selection begins with sourcing. … Quality sourcing is often dependent on the breadth and depth of the relationships an investor has established with managers, with clients, and in the market generally…Once an opportunity is identified, a robust evaluation process must ensue. This process should be repeatable and scalable, and evolve over time…In many ways, due diligence is a search for a consistent story across all areas of a manager.
This is not exactly a precise formula for manager selection which is essential for monetizing hedge fund “benefits.” Their proposal, which is representative of industry literature in general, is to kick the ball down the field or throw a Hail Mary pass in the hopes that a vague, non-specific “manager selection” and “portfolio construction” will make up for the dispersion of manager results and lack of persistence of these results
D. A Study of the Difficulty of Successful Fund Selection
A series of studies released by the Pensions Institute in June 2014 in conjunction with the efforts of U.K. pension funds to measure the cost/benefit of using outside managers in selecting mutual funds provided alarming evidence of the inability of these managers to select funds that outperform.  The studies, which were conducted at the Pensions Institute or the Cass Business School in London, examined 516 UK equity funds between 1998 and 2008, and found that just 1% of managers were able to return more than the trading and operating costs they incurred. But even those managers pocketed for themselves any value they added in fees, leaving nothing for the investor. All the other managers failed to deliver any outperformance – either from stock selection or from market timing.
Star managers are, to quote the report, “incredibly hard to identify”. Furthermore, it takes 22 years of performance data to be 90% sure that a particular manager’s outperformance is genuinely down to skill.  Perhaps the most alarming conclusion was that not only were the vast majority of managers unlucky (i.e., their results could be explained by random chance), but they were “genuinely unskilled” in that their performance was even worse than predicted by random chance.
 Although these studies were based on U.K. mutual funds, there is substantial evidence that similar conclusions apply to U.S. funds.
 This parallels an earlier study conducted by Barra which found that it takes 18 years to identify outperformance resulting from skill among U.S. mutual funds.
Ezra Zask has been actively managing, consulting, teaching, advising, writing and speaking on hedge fund and investment management issues for over three decades.
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