V.
Flies in the Ointment of Hedge Fund Performance
If one views the arguments for hedge funds, the only question becomes “where do I sign up for hedge funds?” According to industry arguments, hedge fund returns handily outperforming both stocks and a balanced portfolio of stocks and bonds. Why then isn’t everyone putting all their money in hedge funds? Because unlike the S&P 500 index or the ML Aggregate Bond Index, there is no way an investor can invest in a hedge fund index. The hedge fund indexes produced by firms such as Hedge Fund Research and Morningstar combine the performance of thousands of hedge funds who voluntarily provide unaudited data. The only way to invest in hedge funds is by selecting individual funds, and there is the major fly in the performance ointment. There are least three flies in this ointment: The first is that hedge fund performance varies widely from fund to fund. The second is that choosing superior performance amongst hedge funds is extremely difficult because historical performance does not guarantee future performance. Finally, the data used to calculate the indexes used in most analyses is greatly if not fatally flawed.
A. Dispersion of Hedge Fund Returns and the Importance of Manager Selection David Swensen and many 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. In fact, Swensen clearly points out that the success of his program depends on Yale’s ability to identify and invest in top-tier performing funds. However, selecting future winners among hedge funds (or mutual funds) is exceedingly difficult, compounded by the fact that many of the best performing hedge funds are either closed to new investors, require high minimum investments and/or long lock-up periods, or charge higher fees; as high as 5% management fee and 50% performance share. The Goldman Sachs research report, The Case for Hedge Funds, also recognizes the dispersion of results among managers, as indicated in the chart below. According to Goldman Sachs’ analysis, the average annual return of hedge funds in the top quartile was a full 19.6% higher than the bottom quartile. This is a further indication of selecting the “right” fund from among the thousands that are available. One way investors have tackled this dilemma is to invest in the largest, best-known hedge funds. Indeed, the hedge fund industry has become much more concentrated with hedge fund assets managed by the top 200 funds.
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