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Hedge funds are surrounded by a certain mystique. There is something secretive about the way they operate. They are regarded as products that can make a profit irrespective of market direction. But are they really appropriate for an institutional portfolio?
Robeco Portfolio Strategist and Researcher Roderick Molenaar has studied the added value of hedge funds for an institutional investor. Together with Thijs Markwat and Rolf Hermans, he has looked into their performance and compared their risk and return characteristics with those of other asset classes. “Investors should be skeptical when looking at the performance of hedge funds,” he says.
Hedge funds form a broad and diverse group of products that invests in other asset classes without a lot of restrictions. They can be long only, short only, or long-short strategies, and sometimes leverage is used to increase performance. The funds can invest in a combination of equities, bonds, currencies and commodities. Often they invest in sometimes exotic, derivatives on these asset classes.
There are many different strategies, but the researchers focused on global macro, equity market neutral and managed futures. Global macro takes both long and short positions in global financial markets, e.g. stock-, bond- and currency markets. Equity market neutral strategies can go long and short and use stock-picking techniques, while trying to remain a net neutral position to the aggregated stock market. Finally, managed futures use forward contracts on mostly commodities and currencies.
“I estimate historical performance to be around 6% per annum when corrected for biases,” says Molenaar. His estimate is considerably lower than the figures in the hedge fund databases, which collect performance data. Hedge fund index performance in the databases is around 9%, equity market neutral is 6%, managed futures 6% and global macro around 11%.
Companies could choose whether or not to submit performance figures for the databases. “In general, the historical hedge fund performance is overstated. There was too much room for bias and this distorts the figures,” says Molenaar: “First, there is survivorship bias. Some funds close down, because they have taken on too much risk or as a result of redemptions. They can just exit the databases and their performance records were removed. Survivorship bias has around a 3% effect on performance. In some rare cases, the reverse is true. Some funds exit the databases because their performance is very strong and they have reached full capacity. They no longer need new money and do not want to be in the databases as part of their marketing efforts.”
‘In general, historical hedge fund performance is overstated’
There is also the ‘backfill bias’, says Molenaar. “Funds build up a track record, but do not necessarily report it. But once they have a good track record to report, they do so and then also include the good years from the past too. This bias has an estimated positive effect of 2% on the results. There have been attempts in the last few years to improve data quality and it has recently become more reliable, but it is a slow process.“
Another major issue for investors is the risk/return profile of hedge funds. Investors should be careful when using the Sharpe ratio (measured as the return above the risk-free rate divided by volatility) to assess hedge funds, warns Molenaar. “Without adjustment, Sharpe ratios are 0.6, higher than those for equities (0.5) and bonds (0.5), but with corrections this ratio is lower. Again, biases play a role here, and they lead in general to inflated Sharpe ratios. When you adjust for biases most hedge fund Sharpe ratios are lower than those of equities and bonds.”
A major problem when assessing Sharpe ratios is the absence of a transparent price for the assets in portfolio, argues Molenaar. “The prices that are reported are more stable than in reality. This underreported volatility has a positive impact on the Sharpe ratio. Underreporting can be caused by investments in somewhat illiquid assets as convertible bonds, for which daily pricing data isn’t always available.”
Hedge funds prefer sticky money, says Molenaar. “That’s why hedge funds are less liquid than other asset classes. They are not always that easy to exit.” He explains how hedge funds operate. “In many cases there is a lock-up period (during which you cannot sell) of three to six months. And there is also the notice period. This means you have to give advance warning of your intention to sell in order for the fund to unwind existing positions. And if you want to exit earlier you sometimes have to pay a redemption fee.”
Sticky money is especially important in implementing less liquid strategies, says Molenaar. “It helps to protect the existing investors. For example, a convertible arbitrage position – buying a convertible bond and shorting the stock – is very difficult to unwind. But for other strategies, such as managed futures, it is easier to unwind trades.”
The correlation with equities and bonds is an important consideration for investors who want to create a diversified portfolio. However, at least as important is how hedge funds behave under different market circumstances. The researchers looked at the performance of hedge funds in a range of equity markets. “In equity bull markets, most hedge funds have a positive performance with the exception of dedicated short strategies, which involve shorting stocks.”
“The correlation with equities depends on the type of strategy, and the performance is very diverse. Managed futures did well when equities perform poorly. In down markets, equity market neutral strategies did badly, while global macro had a break-even record.“
‘Managed futures do well when equities perform poorly’
The correlation of hedge funds with equities is not constant, it fluctuates, says Molenaar. “On average, the correlation of the overall hedge fund market is between 60 and 80%. In terms of diversification this is not very good. But for global macro and managed futures it is less than 40%, which is more suitable for diversification. After the fall of Lehman brothers in 2008, correlation of global macro and equity market neutral with equities rose, while correlation of managed futures fell. In other words, during this crisis managed futures offered better protection.”
He also looked at how hedge funds performed when interest rates fall, because this is very important for pension funds. “Like bonds, some hedge fund strategies tend to do well in times of falling interest rates,” says Molenaar. “Global macro and managed futures perform well in these circumstances, but equity market neutral lags behind.” In general, falling interest rates have a negative effect on coverage ratios and a positive effect on bonds. “For bonds, the correlation in general is lower than for equities, and is negative during times of crisis. “Again, it depends on the type of strategy.”
Besides the (relatively)high correlations with equities and bonds it is also worthwhile mentioning that up to 80-90% of the performance of the overall hedge fund indices can be explained by the returns of commonly used risk factors as equities, bonds, factor investing and various option strategies.
Hedge funds are secretive by nature, says Molenaar. “There is secrecy about what they invest in and who their clients are.”
There are practical reasons for this secrecy. “If they are short a stock and this is well-known in the market it can make it more expensive to unwind a trade. There are exceptions and some funds actively seek media attention in order to put pressure on companies.“
This lack of transparency is an issue for pension funds, says Molenaar. ”The regulators require them to be in control. They need to know what they are investing in and to understand the investment strategy. These demands are sometimes in conflict with the world of hedge funds.”
Another issue for pension funds is the question of whether they can act as a hedge against inflation. Molenaar says that inflation protection should not be the primary reason for investing in hedge funds. “Their strategies focus on absolute return, and inflation protection is not their primary goal.“
The 2% management costs and 20% performance fee charged by hedge funds are still normal, says Molenaar. “Good hedge funds with strong track records are still in a position to demand high fees.”
But he sees some small changes. “There is pressure from pension funds to reduce costs. Some are divesting. For example, Calpers, often considered a leader in the industry, announced that it would withdraw USD 4 bln from hedge funds because of high fees and the complexity.”
”Some Dutch institutional investors no longer want to invest in hedge funds because of the costs, regulatory demands, or because they no longer see the diversification benefits. But other institutional investors still believe in hedge funds.“
He ends with some advice for pension funds: “When allocating to hedge funds, the key is to choose the right fund. You should be able to select a good manager, because you cannot buy a hedge fund index tracker and there are large differences in performance. If you select a bad manager, it can have a significant negative impact on performance.“