Views on improving the integrity of global capital markets
08 May 2012

The Value of Hedge Funds: Recent Studies Reach Different Conclusions

Rhodri Preece, CFA

According to new research sponsored by KPMG and the Alternative Investment Management Association (AIMA), hedge funds are one of the top-performing asset classes over the past two decades. The report, The value of the hedge fund industry to investors, markets, and the broader economy , prepared by the Centre for Hedge Fund Research at London’s Imperial College, finds that hedge funds outperformed traditional asset classes over the period 1994 to 2011, and did so with low levels of volatility, even through turbulent times.

Looking at the numbers, the research shows that hedge funds achieved an average return of 9.07 percent over the review period, after fees, compared with 7.27 percent for commodities, 7.18 percent for stocks, and 6.25 percent for bonds. The research also finds that hedge funds’ ability to deliver superior performance is not associated with significant risk taking: their returns are associated with lower volatility and lower value-at-risk than stocks or commodities.

All this sounds very good, of course. But there is an alternative view of hedge funds, published in Simon Lack’s book, The Hedge Fund Mirage. Strikingly, the book claims that “if all the money that’s ever been invested in hedge funds had been put in Treasury bills instead, the results would have been twice as good.” So how does one reconcile the KPMG/AIMA report findings with those of Lack’s?

One possible answer could be that the average returns quoted in the KMPG/AIMA report were driven by very strong performance at the start of the review period in the nineties. The data in the report seem to support this assertion, based on monthly returns for the Hedge Fund Research (HFR) equal-weighted index, which contains over 9,000 funds (both active and inactive). The HFR index annual returns, aggregated from the monthly data, were 19.7 percent in 1995, 19.43 percent in 1996, 15.88 percent in 1997, and 27.89 percent in 1999, with no years of negative returns in the nineties. By comparison, there are just three years of positive double-digit returns since the turn of the century, and three years of negative returns, corresponding to the dot.com bust in 2002, the sub-prime meltdown in 2008, and the sovereign debt crisis in 2011. So the different time periods over which the KPMG/AIMA figures are measured compared to Lack’s analysis could be one source of the differing conclusions.

According to Lack, a common weakness of hedge fund return statistics is that they often fail to take into account the growth in the total value of assets that hedge funds manage. But given that Lack’s book precedes the KPMG/AIMA report, it’s not clear if this is a factor in this case. Either way, best practice is for money managers to use time-weighted returns when presenting performance information and comply with the Global Investment Performance Standards (GIPS®), which will soon provide focused guidance to asset managers in applying the GIPS standards to hedge funds and other alternative investments. Both the U.K. Hedge Fund Standards Board and U.S. President’s Working Group on Financial Markets recommend that investors require hedge fund and hedge fund-of-fund managers comply with the GIPS standards.

Another source of confusion relates to the split of returns between managers and investors. The KPMG/AIMA-sponsored research finds that investors received approximately 72 percent of all investment profits over the review period, compared to 28 percent for hedge fund managers. In contrast, if Lack’s figures of $9 billion accruing to investors versus $440 billion accruing to managers are true (estimated between 1998 and 2010, factoring everything in including fees paid to fund of hedge fund managers and consultants), the split would be an eye-watering 2 percent to investors and 98 percent to managers.

So what, then, should the average investor take away from all this? Perhaps the most important thing is to demand more from hedge fund managers in the way of transparency and disclosures to enable a full and frank understanding of the strategies, expected risks and returns, and the impact of fees on those returns. And just as importantly, get some assurance that the money being invested is with a manager that adheres to the highest ethical standards and won’t put its own interests before yours. To that end, compliance by managers with the CFA Institute Asset Manager Code of Professional Conduct, the only such code that is focused squarely on putting clients’ interests first, will help investors see the wood for the trees.

As revised 8 May 2012

About the Author(s)
Rhodri Preece, CFA

Rhodri Preece, CFA, is Senior Head of Industry Research for CFA Institute. He is responsible for building and maintaining the global research function at CFA Institute, including leading the planning, coordination, and creation of research content across CFA Institute research platforms, which include the Future of Finance, the CFA Institute Research Foundation, the Financial Analysts Journal, and the Enterprising Investor blog. Preece formerly served as head of capital markets policy EMEA at CFA Institute, where he was responsible for leading capital markets policy activities in the Europe, Middle East, and Africa region. Preece is a former member (2014-2018) of the Group of Economic Advisers of the European Securities and Markets Authority (ESMA) Committee on Economic and Markets Analysis. Prior to joining CFA Institute, Preece was a manager at PricewaterhouseCoopers LLP where he specialized in investment funds.

4 thoughts on “The Value of Hedge Funds: Recent Studies Reach Different Conclusions”

  1. dan says:

    “Yet T-bills returned just 2.3 per cent a year between 1998 and 2010”

    Er, what? Average of numbers used in Lack’s book is 2.99 per cent, and if you used a 10 Year Treasury instead…

  2. Rhodri Preece says:

    Thanks for your comment. Our erroneous reference to the return on T-bills has been removed.

  3. I guess the data isn’t conclusive especially if you count the survivorship bias or backfill bias
    A Very good article inn FAJ in May 2009 exactly had the same point

    http://www.cfainstitute.org/learning/products/publications/faj/Pages/faj.v65.n3.6.aspx

    Measurement Biases in Hedge Fund Performance Data: An Update

    Tending to be static and single-database oriented, existing models for correcting performance measurement biases are unable to detect potential data errors arising from (1) hedge funds that migrate from one database vendor to another and (2) merged databases. In general, return measurement biases can be traced to two key events: when a hedge fund elects to enter one or more databases (backfill bias) and when a hedge fund exits a database (survivorship bias). Artificial rules (e.g., ignoring the first x number of months of performance history to minimize backfill bias) and survivorship statistics based on a single database vendor are susceptible to another form of bias as databases evolve and consolidate. The authors posit that one must be mindful of how much of the hedge fund industry one is observing before passing judgment on the performance statistics of the hedge fund industry as a whole.

  4. Rhodri Preece says:

    Thanks Biharilal. The KPMG/AIMA report notes that the HFR index includes both active and inactive funds, so claims of survivorship bias is not an issue. However, it does not comment on backfill bias. Either way, you highlight some important points about the range of measurement issues that can bias hedge fund performance data, which underline the difficulty of reconciling conflicting results.

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