Hedge Funds and the Active Management Crisis
Active management and hedge funds have suffered what amounts to a mini-meltdown in recent years as ambitious client expectations have collided with complex market conditions and slow, tectonic shifts in the finance landscape. James Bianco, CFA, president of Bianco Research, recently argued at this year’s 60th CFA Institute Financial Analysts Seminar in Chicago that a changing interrelationship between the stock and bond market alongside a plague of high correlations was responsible for recent weak performance of hedge funds and active managers.
“In short, hedge fund performance as a group has been a complete disaster over the past five years,” Bianco said. “So, to earn the standard 2% and 20%, and outperform the index, managers have to be extraordinary. The problem is that there are probably only about 500 extraordinary managers in the world, but there are 11,000 hedge funds.” Active managers have also fared badly. “Over the past 10 years, 76% of active managers underperformed,” said Bianco, “It has been a struggle for most investors to understand how these relationships have changed.” Passive investment is increasingly the default response to such investor confusion.
Performance — No Excuses
While this year has been an embarrassing one for many hedge funds, longer term data suggests most hedge fund indexes perform better than stock and bond indexes and have lower volatility, according to one paper, “European Hedge Funds Industry: An Overview,” summarized in CFA Digest. The European hedge fund industry often outperforms in various strategies and rivals that in the United States, thereby giving investors access to global talents and strategic locations.
Writing in the Journal of Index Investing, Benjamin McMillan of Van Eck Global, in another paper summarized in the latest CFA Digest, asks the question: When does active management add value? McMillan says that, contrary to what other authors claim, actively managed long-short equity hedge funds (currently the largest industry strategy) actually tend to earn negative alpha during periods of market instability. Furthermore, much of the outperformance many equity managers often claim is alpha can be explained as factors, according to Eugene Fama, Kenneth French, and fellow researchers. This seems to leave any remaining alpha attributable to some combination of momentum, fund cash management, and luck rather than any easily attributable skill. Tough times indeed for active managers and their marketers.
More and more absolute return funds are seeing their exposures cloned when drivers of performance can be isolated and replicated. A Comprehensive Guide to Exchange-Traded Funds (ETFs) by Joanne M. Hill, Dave Nadig, and Matt Hougan identified 29 ETF-based absolute return clones and suggested that many hedge funds “lend themselves to factor-based approaches that can be offered within the ETF structure for competitive fees.” That said, the guide also points out that strategies involving derivatives and high degrees of leverage are more difficult to clone using ETFs alone.
Perhaps one of the most wounding analyses of hedge fund performance came from Simon Lack, CFA, who, at the 2012 Financial Analysts Seminar, spoke about the “The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to Be True.” Lack attacked poor transparency, high fees and transaction costs, and the increasing size of the hedge fund industry which together mean that hedge fund investors will likely suffer disappointment. Lack of transparency in the limited partnership structure of most funds is a big issue, especially for investors who must officially report portfolio positions (which many hedge funds don’t allow investors to see). And after the Lehman Brothers collapse and market turbulence, withdrawals from some limited partnerships were restricted, in some cases for years.
New Insight into Hedge Fund Performance Measurement
Investor impatience with excuses from active managers is often expressed as attacks on the investment profession’s tools of the trade: market-weighted benchmarks, volatility measures of risk, hard-to-fathom academic models, and performance fee structures. Speaking earlier this year at the CFA Institute Annual Conference in Frankfurt, Alexander Ineichen, CFA, founder of Ineichen Research and Management AG, argued robustly in favor of hedge funds as part of a diversified portfolio. But for Ineichen they are better suited to an absolute returns yardstick than a traditional market-cap weighted benchmark and any related volatility measures. “They do not define risk as a deviation from a benchmark,” Ineichen said. “They define risk as losing money. I call this total risk.”
To illustrate total risk, Ineichen presented an interesting graph showing the known as a proportion of the unknown.
The small graph in the top left of the figure represents the traditional models of the investment world, incorporating modern portfolio theory in which everything is defined via volatility. The remaining largely shaded portion of the figure signifies the real world. It is “beyond volatility” because it encompasses all the risky aspects, for instance bankruptcy and expropriation, which cannot be easily measured.
Of course, investors have thousands of funds to choose from and for practical purposes must turn to measurement of some kind to help arrive at any decision. In his CFA Institute Research Foundation monograph, Manager Selection, Scott D. Stewart, CFA, urged a high level of caution about simple returns data due to survivor bias and self-reporting in performance databases. In terms of risk measurement, “Alternatives portfolios commonly incorporate leverage, non-linear-payoff option-like exposures, and other unusual characteristics that make linear risk measurement problematic,” Stewart wrote. “As a result, return standard deviation is a poor measure of risk.”
Simon Lack, CFA, takes a different approach: “performance measurement has focused mainly on the average annual return or time-weighted return of hedge funds. I thought it would be helpful to look at the asset-weighted return, or internal rate of return (IRR), to examine how the clients have done in aggregate. A big difference exists between the two. The IRR provides a more sobering assessment of hedge fund performance.”
Ease of Recognition for End Users
Even if returns are satisfactorily calculated and biases in hedge fund indices deciphered, equities, fixed income, and illiquid assets pose many difficult challenges for risk measurement as discussed in recent years by Deborah Kidd, CFA, in a series of topical articles written for CIPM designation holders. On the risk side, there are forward looking (VAR and cVAR) and downside risk (Sortino ratio) measures available. But these do not seem to have the end-user recognition and ease of understanding of measures based on traditional benchmarks and risk definitions: for example, the Sharpe ratio, Information ratio/ tracking error, and measures devised by Jack Treynor and Michael Jensen.
As unconventional central bank policies help ensure abundant footloose capital, chasing after any hint of positive returns worldwide, every basis point of returns counts for hedge funds. Hence the recent focus on high frequency algorithmic trading, now more than 50% of all trades in the US, and which is often suspected of disadvantaging low-frequency trading. In “Expected Return in High-Frequency Trading,” summarized in CFA Digest, Rick Cooper and Ben Van Vliet of the Illinois Institute of Technology develop an alpha attribution model for high-frequency trading, explaining its components and the trading tactics used to implement high-frequency strategies.
In this environment hedge fund fees are likely to remain under pressure with some investors bargaining hard for tighter fees pricing and even rebates. But with hedge fund performance it seems the devil is always in the details. Writing in the Financial Analysts Journal, researchers from Ghent University discussed a number of fee-related insights that may be useful to hedge fund investors. Their research found the expected total fee load charged by the hedge fund manager increases with the crystallization frequency. For the Commodity Trading Advisors (CTAs) category of funds studied, moving from annual to quarterly crystallization leads to a 0.49% escalation of the average annual fee load assuming typical 2% and 20% performance fee structures.
For further reading on the crisis in hedge funds and active management, see:
- “Diverging Markets and Shades of 2007” (forthcoming in CFA Institute Conference Proceedings Quarterly): The financial markets have seen some significant historical changes in recent years, some of which have been driven by the Fed’s accommodative monetary policies. The correlation between stock returns and bond returns has gone from positive to negative, and correlations between stocks have surged to more than 50%. Durations and dealer positions are at record levels in the bond market, and long-term bond returns have been outpacing long-term stock returns. Some of these changes may reverse themselves when the Fed starts to raise rates, but the economy is currently not in a position to absorb a rate hike.
- “Hedge Funds and Risks in the Diversified Investment Portfolio”: The risks of alternative investments should be demystified. A variety of strategies are used by absolute return managers to hedge noncompensated risks — that is, exposure to accidents and losses. Investors should note the importance of the asymmetry of returns and compounding capital positively. Diversification is the only “free lunch” in finance.
- “The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to Be True”: The combination of a lack of transparency, high fees and transaction costs, and the increasing size of the hedge fund industry, which increases efficiency and lowers returns, means that hedge fund investors are not earning the returns they expect to earn. Today’s hedge fund investors are investing in a space that is mean reverting. They are ultimately momentum investors because returns are the only data they have. But those returns are not persistent.
- “European Hedge Funds Industry: An Overview”: Given the rapid growth in hedge funds in the European market and the absence of literature directed at this market, the authors attempt to fill the void by analyzing the growth, structure, and performance of European hedge funds. They conclude that this market now rivals the North American market.
- “When Does Active Management Add Value?”: The hedge fund industry claims that actively managed funds can offer uncorrelated alpha compared with traditional investments. Attempting to gain insight into the value added from actively managed long–short equity hedge funds, the author finds that as a group, they tend to produce negative alpha during periods of market instability — the opposite of what they claim.
- “Crystallization: A Hidden Dimension of CTA Fees”: The authors investigated the impact on fee load of variations in the frequency with which commodity trading advisers update their high-water mark.
- “Expected Return in High-Frequency Trading”: The alpha attribution model for high-frequency trading is developed by explaining its components and the trading tactics used to implement high-frequency strategies. The results demonstrate why high-frequency traders need to be fast to generate positive expected returns and why they are better at providing liquidity.
- Manager Selection: Manager selection is a critical step in implementing any investment program. Investors hire portfolio managers to act as their agents, and portfolio managers are then expected to perform to the best of their abilities and in the investors’ best interests.
- “Deciphering the Biases in Hedge Fund Indices”: All indices contain biases resulting from weighting and construction methodologies, but unique aspects of the hedge fund industry create an additional set of biases and complexities for investors in hedge fund indices to evaluate.
- “Value at Risk and Conditional Value at Risk: A Comparison”: Value at risk is praised as a simple, universal risk measure on the one hand and frequently referred to as “controversial” or “hotly debated” on the other. This article examines two key limitations of the measure.
- “The Sortino Ratio: Is Downside Risk the Only Risk that Matters?”: This article, the third in a series to examine risk-adjusted performance metrics, focuses on a commonly used measure of downside risk — the Sortino ratio.
- “The Sharpe Ratio and the Information Ratio”: The Sharpe ratio and the information ratio are routinely used in performance assessment; they are among the original risk-adjusted performance measures. Though they are simple metrics, practitioners should take care not to use them naively.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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