The hidden drivers of hedge fund performance

September 22, 2015

At the beginning of the millennium, hedge funds were en vogue. Institutional and private investors could not quite get enough of them, as they thought that these funds had the ability to perform regardless of the market environment. The industry went through a phase of rapid growth, and the number of funds as well as assets under management ballooned. The valuation of most asset classes increased, making the life of hedge fund managers and that of the bankers lending them money, quite easy and sweet.

The party went on until 2008, when hedge funds in aggregate lost at least a quarter of their value according to the most widely followed investment benchmark (the HFR Global hedge fund index). Smaller funds started to shut down. The asset class attracted a lot of bad press. Scandals such as the Madoff Ponzi scheme exposed the danger of investing with hedge funds and the importance of proper due-diligence. Overall, as Simon Lack explains in his 2012 seminal work on hedge fund performance, “The Hedge Fund Mirage”, between 1995 and 2012 investors would have been better off invested in treasury bills, which have done better with essentially no risk. Yet the industry as a whole continues to grow, now reaching an estimated $3,000 billion of assets under management in aggregate.

At MONOGRAM, we are firm believers in Occam’s razor, which basically states that the simplest way to achieve a goal is the best. We also observe that the financial industry broadly disagrees with us, putting a large premium on complexity. Simply put, complicated investments should perform better or exhibit less risk. This of course, is directly contradicted by the facts. For example, a balanced portfolio invested 60% in Global Equities and 40% in Global Bonds has outperformed hedge fund indices every single year but one in the last ten.

Apparently, even hedge funds managers themselves believe in the superiority of simple investments since they have over time derived a large proportion of their performance from the simplest investment available to them – cash deposits. How do they do that? Hedge funds are mostly, as their name suggest, “hedged” vehicles. Schematically, this means that they borrow securities against a small fee from their prime broker (a bank typically), sell them, and buy other securities with the proceeds. This process leaves the fund’s cash balance largely untouched. Hedge funds can then decide to invest their cash balance in the money market and get paid an interest against that. When interest rates are at zero such as now, the effect is trivial. However, US short-term interest rates have averaged 4.2% between 1990 and 2008. This massive tailwind to hedge fund performance is gone and nowhere near making a comeback.

Secondly, as more hedge fund capital chases the same trading opportunities, competition increases and returns diminish. In the 1990s, traders could easily make 3 to 5% per annum with a simple “cash-and-carry” strategy – arbitraging two similar securities (typically in fixed income markets) trading at different valuations by selling the expensive one and buying the cheap one.  Adding to that, a decent amount of leverage makes for very decent profits without much risk or work. Today, these trading opportunities have been completely arbitraged away.

The hedge fund footprint on some markets has grown to levels that makes them risky and no longer profitable. Such is convertible arbitrage, which involves buying convertible bonds and hedging away the various market risks, a process that effectively leaves a hedge fund with a free option on the value of the issuing company. This worked very well at the end of the 1990s and the beginning of the 2000s, at which point hedge funds owned an estimated 80% of all convertible bonds outstanding (a market estimated at c. $500 billion in the US). In 2007, when they started losing money on the other strategies they had in their books, their prime brokers (i.e. their bank) forced hedge funds to reduce their leverage, which they had used to the tune of c. 3:1. Hedge funds had no choice but to sell their positions regardless of valuations. As everyone ran for the exit at the same time, convertible bonds valuation went in free fall, and investors in this strategy lost on average 60% of their money.

Against all odds, the disappearance of trading opportunities, the increasing competition, and the disappointing performance has not taken a toll on hedge funds fees. Rather, the contrary can be observed. According to a 2014 JPMorgan survey, fees have increased from last year to an average of 1.69% p.a. management fee and 19.13% of gains (1.64% and 18.99% in 2013). This comes in addition to various costs such as administration, custody, legal, prime brokerage, trading and even office rent and salaries on occasions. Given that, simple models show that a hedge fund making 10 to 15% before costs and fees would four out of five years leave investors with annualised returns in the region of 7 to 8% net at best. In the long run, hedge fund managers capture an estimated 50% of the profits generated with your money. No wonder there are so many hedge fund billionaires and so many disappointed investors.