20 JULY 2017 While the recent performance of hedge funds has been abysmal, the industry continues to attract assets, especially from pension funds. How do we explain this anomaly? One argument is that hedge fund performance should not be compared to the S&P 500 because hedge funds […]
While the recent performance of hedge funds has been abysmal, the industry continues to attract assets, especially from pension funds. How do we explain this anomaly? One argument is that hedge fund performance should not be compared to the S&P 500 because hedge funds seek to reap absolute returns or provide superior risk adjusted return. Another argument is that hedge funds add diversification benefits to portfolios.
A better explanation of hedge fund returns is to admit that performance varies according to the economic and market context in which they are generated. We have been tracking hedge funds since the early 1990s. Since then the economic environment, financial markets and hedge fund strategies have changed radically. Trying to explain hedge fund returns without taking this into account is like trying to explain tides without reference to the moon. A recent research report, “A New Era for Hedge Funds?” by Lyxor Research offers an extended discussion of this issue, reinforcing the points made above. The report addresses the main problem head on: “…hedge funds have in fact underperformed traditional asset classes since 2009.” They argue that hedge fund returns overall have actually been outstanding. The problem is in trying to make an argument for hedge fund performance for periods when they clearly underperform.
Source: “A new era for hedge funds?” Lyxor Research, July 2015
Lyxor presents the factors that drive hedge fund performance:
“We evaluated the causes of the underperformance [since 2009] and find that the fall in bond yields in the wake of the Fed’s QE program has negatively impacted hedge funds. Additionally, the equity beta has fallen while stocks rallied and alpha generation has shrunk for the very same reason.”
Looking back at various business cycles over the past 25 years, Lyxor finds periods that were favorable to hedge funds and others that were not.
Source: “A New Era for Hedge Funds?” Lyxor Research, July 2015
While many will argue with particular aspects of Lyxor’s analysis, their analysis is more fruitful than the typical “hedge funds outperformed the S&P 500 over the past week.” It provides a framework that is similar to that used to explain traditional asset classes: that the strategies should be evaluated on their performance over a series of business cycles. Returns for one year or even 5-year periods do not tell us anything about the future performance of hedge 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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