Hedge funds have come under increased scrutiny in the past couple of years, largely in part due to their underperformance relative to those of conventional assets. Disappointing headlines of lackluster returns, negative publicity surrounding manager compensation, and CALPERS’ decision to withdraw from hedge funds altogether – all points which have been addressed in previous posts on our blog – no doubt reflect a growing disenchantment with the hedge fund industry. However, a proper discussion of hedge fund performance in the broader context of portfolio inclusion warrants a closer inspection of the methods used to evaluate these strategies. What we’ll find is that simply evaluating hedge funds on an absolute return basis is not enough to demerit their inclusion in well-balanced portfolios.
Absolute vs. Relative Returns
At face value, the mediocre returns of hedge funds over the past few years may dismay many investors that are unfamiliar with the space. It’s undisputable that hedge funds have underperformed equities and bonds on an absolute return basis. The Barclay Hedge Fund Index gained 2.89% in 2014, while the S&P 500 gained over 13% and the United States Aggregate Bond Index rose over 5%. When evaluating hedge funds, however, it’s crucial to understand the distinction between absolute and relative returns. A relative return is a return that an asset achieves over a period of time compared to a benchmark. Mutual funds, for instance, are designed to track and beat an underlying benchmark such as the S&P 500. If the S&P 500 is down 20% one year and a mutual fund is down 15%, the manager of that mutual fund can validly boast superior performance.
Absolute returns, on the other hand, are not compared to any benchmark. Hedge funds tout the ability to provide steady, positive returns regardless of market conditions. As such, hedge funds are not designed simply to beat a benchmark, but to provide consistent and positive absolute returns. A common misconception is that hedge funds are supposed to achieve outsized absolute returns. On the contrary, many investors who allocate to hedge funds would often rather have steadier returns with lower volatility than higher ones with higher volatility. While it’s true that some of the best-known hedge funds made their claim to fame through highly profitable bets, the vast majority of hedge fund strategies share the primary goal of providing steady return streams year after year.
Risk-Adjusted Returns
This goal of providing superior risk-adjusted returns should be the benchmark by which hedge funds are evaluated. A quick comparison of the Sharpe Ratio (the industry standard for calculating risk-adjusted return) of hedge funds with those of other indices shows that hedge funds have consistently outperformed the S&P 500, MSCI World, and Barclays Bond Index in terms of risk-adjusted returns. In this line of thinking, hedge funds are not meant to replace equities or bonds altogether. Rather, they’re intended to complement existing allocations to traditional assets to improve an overall portfolio.
As many hedge funds are created to protect during drawdowns over a longer time horizon, we also need to adopt a long-term view of their performance in comparison to other asset classes. The below graphs show how hedge funds fared during the two most recent periods of market stress, the dot-com crash and the global financial crisis. Relative to other asset classes, hedge funds provided more downside protection during these periods.
Diversity of the Hedge Fund Industry
Hedge funds, as a collection of investment strategies, don’t necessarily fit into a catch-all bucket. Different strategies exhibit widely varying returns, and industry data should be segregated by strategy rather than a one-size-fits-all asset class. For instance, a fixed income hedge fund strategy is vastly different from an equity long/short strategy because of their underlying asset classes and instruments. By natural extension, comparing an equity long/short hedge fund’s performance to bond indices wouldn’t reveal meaningful insights as the two behave and operate in different ways.
Needless to say, the hedge fund industry has grown tremendously in the past ten years. Even within the same strategy, we can find a large dispersal of performances and quality funds. There are hedge funds that consistently perform in the top quartile, regardless of the industry’s overall performance in relation to other indices. Thus, a snapshot generalization of an entire industry based on a single metric is misinformed decision-making at best. Investors should consider the merits of hedge funds on a case by case basis, evaluating how well certain strategies fit into their specific risk-return objectives.
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