Approach hedge funds with caution despite their moment in the sun

Attention hedge-fund investors: I have some good news for you ... I also have some not so good news.

The good news is that in 2017 hedge-fund managers generated the best annual returns in four years. According to a recent report from Hedge Fund Research, funds gained 8.5 per cent last year. On an asset-weighted basis, the gains were 6.5 per cent, still the best annual performance since 2013. Profits for the managers and general partners were also at four-year highs.

The not so good news? For investors (or limited partners), these funds on average are still lagging behind broader indexes. To cite just one example, the Standard & Poor’s 500 Index had a total return of 21.8 per cent last year – more than double the average for hedge funds. And many overseas markets – especially for investors using US dollars – did even better. The iShares MSCI Emerging Markets, for instance, had a return of 37.1 per cent.

This matters a great deal. Hedge funds have assets under management of about US$3.3 trillion, much of it in the US pensions, endowments, foundations and other large institutional public investors, along with many ultra-high net worth individuals, have put money in these alternative investments.

The HFR report inadvertently reveals how difficult it is to track performance relative to benchmarks within the hedgefund industry. There are many different types of funds, and the list keeps getting longer.

Start with the traditional long/short, arbitrage and macro hedge funds, as well as event-driven and activist funds. Don’t forget distressed and restructuring funds. Add to that the risk-parity strategies and relative value funds. I would be remiss if I omitted multistrategy, yield alternative or asset-backed funds. And this year there is a new category: blockchain funds.

No wonder investors are confused. Each of these has different risk profiles, investment objectives, expected returns and benchmarks. Even worse, as noted many times before, the combination of high fees and underperformance means achieving real above-benchmark returns is rare.

Human cognitive foibles and behavioural economics explain the hedge-fund attraction, despite a track record during the past decade of significant underperformance – at least on average. For reasons that have yet to be explained by methods other than self-delusion, the expectation for funds to deliver market-beating returns endures.

There is something else at work. Public pension managers take the overstated anticipated returns of alternative investments and work them into calculations of how much state and local governments must contribute to the pension funds. The bigger the projected returns, the less money governments must allocate and the less taxpayers have to foot the bill.

It’s a deception of huge proportions, leaving taxpayers on the hook for future shortfalls, while beneficiaries are misled into believing they will receive more than the pension funds are able to deliver.

Other issues

Performance: we don’t really know what the industry’s returns actually are. Unlike for mutual funds, there is no performance reporting requirement mandated by securities regulators. Hence, we see self-reporting by funds when they have a good quarter or year, and radio silence when they don’t.

That is before we get to the survivorship issue, a serious concern given that about a quarter of funds dissolve each year. In other words, those with the worst returns disappear and don’t figure in calculations of total industry returns.

Benchmarks: as the list above shows, it is a challenge to create a meaningful benchmark for many fund categories. The S&P500 is rather arbitrary for many types of finds. Not having a credible benchmark for performance comparisons gives investment managers fits when trying to evaluate funds. Fee pressure: the hedge fund industry isn’t immune to a phenomenon visiting the rest of the financial industry. The old days of 2 and 20 – that’s 2 per cent of assets under management, plus 20 per cent of gains – is fading. Anecdotally, more and more funds seem to be moving towards 1 and 15.

Performance: it’s feast or famine. Emerging managers seem to be in the pool that generates the best returns, but finding and evaluating them is a costly, time-consuming process. On the other end of the spectrum, many of the best performers are well-established giants with long track records. Many of those are closed to new or smaller investors.

Hedge-fund investors today confront complex choices, reduced but still high fees, and improved but still underperforming returns. Unless you are fortunate enough to be in the top 5 per cent of alpha generators – those who deliver market-beating performance – almost all investors are still better off with simple low-cost funds.

We see self-reporting by funds when they have a good quarter or year, and radio silence when they don’t