Practical analysis for investment professionals
24 February 2016

Hedge Funds: What Are They Good For?

Absolutely nothing.

That is the answer to the title’s question. It is also what hedge fund investors receive in return for shelling out exorbitant fees.

The chart below looks at historical performance of hedge funds (blue bars) relative to diversified stocks (yellow bars) and bonds (green bars). It’s obvious that hedge fund performance has been relatively poor.

Asset Class Performance Comparison

Asset Class Performance Comparison

Biases in Hedge Fund Data

The dramatic underperformance of hedge funds is pretty amazing considering the survivorship and backfill biases in the index data that skew hedge fund returns upwards by 3% to 5% per year.

Survivorship bias refers to hedge fund indices only showing returns earned by funds currently in the index. The index does not include funds that previously reported returns but stopped reporting due to poor performance. The implication is that hedge funds only report when they are successful and stop reporting once they have a string of bad results, leading to the index returns being artificially high.

Backfill bias also has dramatic impact on various hedge fund indices, including the HFRX Global Hedge Fund Index in the chart above. Backfill bias occurs when an index provider adds a new fund to their index and “fills in” prior returns of that fund (which are presumably good). For hedge fund managers, this typically means establishing a fund with seed money and then waiting to report results until returns are sufficiently high to start marketing the fund, thereby raising money using the allure of strong past performance. The end result is a process that overstates returns.

Both biases stem from the fact that hedge funds are not required to report their performance — all reporting is entirely voluntary. Whether you look at an aggregate index such as the HFRX Index or at the performance of a specific strategy, hedge funds report data to show higher performance than was actually realized.

Relative Skill Trumps Absolute Skill

Don’t get me wrong, there are smart hedge funds managers out there. However, absolute skill has less to do with the probability for success than relative skill where everyone is competing hard for a shrinking pool of excess returns.

Most hedge fund investors think they are able to identify the best managers in advance. Perhaps some of these statements sound familiar.

“We only pick the best managers.”

“Our process is second to none.”

“We have access to managers and data that others don’t.”

Mathematically speaking, these statements can’t hold true for everyone. It’s much like how 90% of people think they are above-average drivers — in reality, only 50% of people can be above average.

And even being above average does not necessarily translate to outsized returns. The distribution of returns is not a normal, even distribution; instead, returns are heavily skewed such that a handful of managers crush the industry by a significant margin.

The 20 most profitable hedge funds in 2015 earned $15 billion, while the rest of the industry lost $99 billion, according to Bloomberg. This isn’t unusual. Good luck picking the winning managers in advance, though. Only a small group of people have demonstrated the ability to do so.

The Yale Model

David Swensen, CIO at Yale University, developed a model (popularly known as the Endowment Model or Yale Model) based on modern portfolio theory that invests heavily in alternative and illiquid investments. Swensen’s success at Yale has provided the hedge fund industry with an example of why people should be using Swensen’s products and strategies. Unfortunately, replicating the Yale Model is unrealistic for the vast majority of individual and institutional investors.

Yale (and a handful of select competitors) has an entire team dedicating 100% of their time to hedge fund evaluation. Most family offices or financial advisory firms have only one or two people to dedicate to alternatives, and those people frequently have other responsibilities, too. The career risk for most financial advisers is also substantially higher than for the Yale endowment employees, which leads to an increased probability of performance chasing and herding behavior.

The Yales of the world have unprecedented access to managers and a level of transparency beyond published updates that other investors simply don’t get. For example, these big players receive daily holdings reports or the first phone call from a manager when something is wrong.

Furthermore, Yale has the ability to tolerate illiquidity in a way that makes them a more attractive match for hedge funds. This also allows them to sit through years of underperformance. They have the portfolio size to properly diversify across managers and the clout to structure investment agreements in more favorable terms than the average investor.

So, yes, there is a way to increase your odds for success with hedge fund exposure. Unfortunately, most can’t do it.

The Allure of Hedge Funds

The allure of hedge funds revolves around an ever-changing narrative that plays off investors’ emotions and fears but always centers on uncorrelated profits with minimal downside risk. Plus, it’s always easier to blame someone else when using a complex investment strategy, as opposed to blaming only oneself when a passive portfolio doesn’t work out.

Hedge fund exposure fails to deliver for investors due to exorbitant fees, high competition, the ineffectiveness of active management, and a general misunderstanding of the underlying exposures and correlations (i.e., hedge funds don’t hedge). But the purpose of hedge funds from the perspective of the manager, parent company, consultants, and brokerages is to collect fees. In that sense, hedge funds have been a huge success each and every year.

Below is a profit and fee analysis using the methodology from The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to Be True by Simon Lack, CFA, and publicly available data from BarclayHedge and Hedge Fund Research.

Investors’ Real Profits vs. Estimated Hedge Fund and Fund-of-Fund Fees in Billions of Dollars, 1998–2015

Investors' Real Profits vs. Estimated Hedge Fund andFund-of-Fund Fees in Billions of Dollars, 1998-2015

The methodology understates hedge fund profits for a variety of reasons, but you can still see that running a hedge fund has been a good business in both good and bad markets. In fact, Lack’s most recent data shows that hedge funds captured 84% of the profits and fees from 1998 through 2014; conversely, investors captured only 5% (fund of funds captured the remaining share).


Let’s revisit our original question. Hedge funds: What are they good for?

Absolutely nothing is still the accurate response for most investors. For the managers, parent companies, consultants, and brokerages that collect fees, however, they are a money tree.

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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.

Image credit: ©

About the Author(s)
Peter Lazaroff, CFA, CFP

Peter Lazaroff, CFA, is the Director of Investment Research and a Wealth Manager at Plancorp, LLC based in St. Louis. Peter is a CFA Charterholder and CFP® certificant. He holds a BA in economics and management from DePauw University.

16 thoughts on “Hedge Funds: What Are They Good For?”

  1. RupertH says:

    Bold statements to make, but I must respectfully disagree with a few points.
    First off, to assume that all investors are looking for are high returns as presented in the first graph shows a misinterpretation of the purpose of an alternative source of returns for diversification within a portfolio. Granted many hedge funds (by design) are highly correlated to equity markets, but to paint them all with the same brush is incorrect; think of the purpose of an equity market neutral fund with a beta of zero and expected return of 5-10% in a portfolio for instance.
    Secondly I agree that biases exist within hedge funds indices, but an index such as HFRX is investable so if that is your worry then why not just invest in the index?
    The third and final point I would like to point out is your interpretation of 50% of a distribution being on either side of the “average”. “Mathematically speaking” it is actually very easy for more than 50% of people to be above average when there is skewness in a distribution – a point you raise in the next paragraph. For example the average of (90,90,90,90,0) is 72 so in this case 80% are above average.
    It may be the case that hedge fund selection within a portfolio of traditional assets is a challenging task for a traditional team, but there are multiple options out there in the form of investable indices for exposure to the HF industry as whole or lower cost FOHF managers for selective exposures that can overcome this burden.

  2. By your own logic, businesses are good for absolutely nothing too.

    Everyone that is starting, running or working for a business, should just quit and terminate the business.

    Of businesses:
    25% blow up in Year 1
    50% blow up by Year 4
    71% blow up by Year 10

    So there you go, all businesses are absolutely good for nothing. Time for us to just throw away capitalism, long live the socialist state… LOL

    Everyone loves to jump on the “I hate rich hedge funds” bandwagon.

  3. Adam says:

    This article is very misleading and offers no real insight. HFRX are not the best indices and most in the hedge fund space should know this. Also, there is no backfill of HFR’s indices. Backfill bias comes from databases, not indices. Additionally, risk and correlation mean something. If you want to present something, present investors’ real experience in hedge funds and then look at the efficiency of their portfolios with, and then without the hedge allocation.

    1. Brad Case, PhD, CFA, CAIA says:

      Great question, Adam. Peter’s conclusion is absolutely correct, but it’s useful to present investors’ actual experience in hedge funds and look at their portfolios with and without the hedge fund allocation. In fact, for that purpose let’s look at the largest, most sophisticated investors in the entire country.
      That’s exactly what CEM Benchmarking did. The company collects data on the actual investment results of hundreds of large public and corporate pension funds, and it summarized those actual returns in a report published in 2014 called “Asset Allocation and Fund Performance of Defined Benefit Pension Funds in the United States Between 1998-2011.” (The report, which was sponsored by NAREIT, my employer, is available for download at
      Hedge funds were the absolute worst among all 12 asset classes, according to CEM Benchmarking’s data. Net total returns over the 14-year historical period averaged just 4.77% per year: worse than all three categories of equity investments, worse than all four categories of alternative investments (other than hedge funds), and even worse than all four categories of fixed-income investments!
      As for investing their portfolios “with and without the hedge allocation,” CEM Benchmarking did exactly that, calculating the marginal impacts of a 1% increase in the allocation to each asset class. A marginal increase in the hedge fund allocation would have REDUCED average pension fund returns by 2.1 basis points per year. Only three other asset classes showed negative marginal impacts, and only one of them (U.S. large cap equities during what was called the “lost decade”) had a larger negative marginal impact than hedge funds.
      While you’re at it, check out “Higher Risk, Lower Returns: What Hedge Fund Investors Really Earn” by Ilia D. Dichev & Gwen Yu, published in Journal of Financial Economics and available at Using data for the period 1980-2008 they found that “dollar-weighted returns are reliably lower than the return on the S&P 500 index, and are only marginally higher than the risk-free rate as of the end of 2008. The combined impression from these results is that the return experience of hedge fund investors is much worse than previously thought.”

      1. Adam says:

        A study sponsored by NAREIT found REITs to be the best investment! As a Phd, CFA, CAIA I’m sure you recognize what Sharpe Ratio is. Also, I like how data ended in 2011. FTSE/NAREIT All REITs index had an astounding 23.3 standard deviation from 1998 – 2011. HFRI Comp had 7.6 standard deviation. From Jan 1998 through Dec 2011, HFRI had a Sharpe of 0.6 which was higher than all but bonds. REITs had a 0.2 Sharpe while equities clocked in lower than 0.1. HFRI returned 7.1 with 7.6 stdev while REITS were 7.5 and 23.3.

        If you go through 2015, HFRI returned 6.5 with 7 stdev and Sharpe of 0.6. REITs improved to 8.6, 21.4 and 0.3. Equity indices Russell 1000, 2000 and MSCI World ex US returned 6.4, 6.8 and 4.6 with Sharpes of 0.3, 0.2 and 0.1.

  4. David Einhorn says:

    It appears we have an author and commentor that couldn’t make it into the HF world.

    1. Brad Case, PhD, CFA, CAIA says:

      I’ll assume, David, that you’re making a joke based on the phenomenal, and phenomenally misplaced, self-regard and overconfidence of hedge fund managers. And I’m smiling with you.

    2. John McClelland says:

      The ad hominem attack, always a strong move.

      1. Brad Case, PhD, CFA, CAIA says:

        My thought exactly, John. Thanks.

  5. Brad Case, PhD, CFA, CAIA says:

    A guy who won’t reveal his last name or professional affiliation touts hedge funds!
    You’re right: one of the greatest selling points of hedge funds is that they can invest in Level 2 and Level 3 assets as well as Level 1 assets, and by so doing they can understate their monthly volatility, which makes them look less volatile than they really are, and which also makes them look as though they have better risk-adjusted returns than they really do.
    Another great selling point is that they can report returns as measured by indices such as the HFRI that incorporate impressive reporting biases. But I assumed that was why you said “present investors’ real experience in hedge funds,” which is exactly what CEM Benchmarking did. So why is it that when hedge funds ended up being the absolute WORST asset class that actual investors held, suddenly you don’t want to look at “investors’ real experience in hedge funds”?
    If you think CEM Benchmarking’s data are wrong, Adam, tell me what’s wrong with them. If you think they screwed up their analysis, tell me what they did wrong. But don’t hide behind your anonymous screen name smirking about who paid for them to look at their data.
    The time period 1998-2011 was the longest one that they have. Net total returns since then according to the HFRI (your choice, even though it’s non-investable) have averaged just 3.55%, with an 88% correlation to the Russell 3000 using monthly returns. Over the same period REITs (the FTSE NAREIT All Equity REITs index) have provided gross returns averaging 11.57% (meaning net returns around 11.07% for an actively managed portfolio) with a correlation of just 46% to the Russell 3000.
    Peter is still right: hedge funds are still good for nothing.

  6. Hedge funds began to run into the limits to arbitrage in the late ’90s. Since then, most of them that don’t limit the size of their funds have not done well. There are some clever hedge funds pursuing “proprietary” niches. Most aren’t taking new clients. After all, and strategy can get too much money — it doesn’t mean the idea is invalid, just crowded. As such, assets have to exit hedge funds on net.

    1. second last sentence and s/b any — sorry.

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