We are probably the most popular hedge fund tracking website in the World. Hedge funds weren’t a very popular topic among financial journalists when we launched our site 4 years ago. Nowadays we read at least a dozen stories about every week and all of them either contain blatant mistakes or exclude vital facts about hedge funds. We haven’t seen a factually complete article about hedge funds over the last 4 years, so we decided to write one. Here are the 6 things you probably didn’t know about hedge funds:
1. You shouldn’t compare hedge fund returns to the S&P 500 index’s return. These days hedge funds are about 50-60% net long. If the market goes down 36%, an average hedge fund will probably go down about 18-21% because of the decline in the market. That’s what we observed in 2008. If the market goes up 30%, an average hedge fund will probably be up about only 15-18%. It isn’t surprising at all to see hedge funds underperform in a bull market and outperform in a bear market. It isn’t rocket science.
2. There are three components of net hedge fund returns: return that’s a function of beta exposure, abnormal return generated because of fund manager’s skill (this is called alpha), and management and performance fees. We explained the return generated by beta exposure in the previous section. There is no skill involved in generating returns by being 50-60% net long. If you allocate 50-60% of your portfolio to an index fund, you can easily replicate an average hedge funds’ returns pretty accurately. Hedge fund managers used to generate high single digit alpha until 2005. More recently the average alpha generated by an average hedge fund went down below zero (see the figure below as calculated by quant hedge fund manager Cliff Asness). This is an approximation but other methods will probably yield similar results. Asness’ analysis uses “net hedge fund returns”. This means hedge fund managers can’t generate enough alpha to justify their sky high management and performance fees. In other words, if you had allocated 50-60% of your portfolio to an index fund and kept the remaining portion in T-bills, you would have outperformed the average hedge fund investor by a couple of percentage points per year over the last couple of years.
3. This doesn’t mean that hedge fund managers are complete idiots when it comes to picking stocks. Remember, they charge close to 2% in management fees and close to 20% in performance fees. So, if their raw return due to beta exposure is 15%, their investors will have to pay 2 percentage points in management fees and 3 percentage points in performance fees. If they are able to generate 3% in alpha (extra return), again 0.6 percentage points will be deducted as performance fees. Overall, the fund investors will realize about 12.5% in net returns or about 2.5 percentage points below what they would have achieved on their own in index funds. In this example, the hedge fund manager was able to generate an alpha of 3 percentage points but this wasn’t enough to justify his fees of about 5.5 percentage points. In other words, hedge fund managers can still beat the market by picking the right stocks on average, but the margin isn’t big enough to justify their fees. Usually nobody tells you this. Does this mean that you should avoid hedge funds and invest in index funds? Please don’t answer this question yes.
4. Why do we observe a negative trend in hedge fund alpha over the last decade? We haven’t seen anyone provide a satisfactory answer that’s supported by cold hard data. We have quarterly 13F filings of almost all hedge funds. These filings show each hedge fund’s long equity positions in US stocks at the end of each quarter. Our analysis has shown that hedge funds have been increasingly investing in large-cap stocks as they attract more and more assets from dumb pension funds (yea, we call them dumb because they don’t try to do the right thing; they do the safe thing to keep their jobs). Our research has shown that hedge funds’ most concentrated stock positions in large-cap US equities outperformed the market by less than 2 percentage points per year BEFORE fees. Remember, hedge funds charge 2% in management fees and another 2% in performance fees (assuming their average return is 10%). So, hedge fund managers took advantage of their dumb investors by investing in large-cap stocks. They probably know that they can’t generate enough alpha in large-cap stocks but the hedge fund industry is now managing close to $3 trillion today. They have no other choice; they have to invest this influx of capital into large-cap stocks.
5. So, hedge funds can’t generate enough alpha in the large-cap space and we know that they have been generating decent alpha until very recently. How did they do that? The answer is very easy but we haven’t seen anyone spit this out in the media. Our research has shown that hedge funds’ small-cap picks outperformed the market by double digits between 1999 and 2009. The 15 most popular small-cap stocks among hedge funds outperformed the S&P 500 index by an average of 18 percentage points per year in the same period. This is a fact, it isn’t an opinion. Unfortunately hedge funds have only a limited number of opportunities in the small-cap space. As they invest a larger percentage of their assets into large-cap stocks, the alpha they generate in the small-cap space wasn’t enough to cover the shortage of net alpha in the large-cap space.
By the way don’t even think for a second that we made a mistake in our calculations. I have a PhD in financial economics and I am quite familiar with these kinds of calculations. Currently we are downloading all hedge fund 13F filings that are filed after 2009 and we will repeat this analysis for recent years as well. Fortunately two years ago we started publishing a quarterly newsletter and shared the list of 15 most popular small-cap stocks among hedge funds with our subscribers in real time. Since the end of August 2012, these 15 stocks generated a cumulative return of 93.7% vs. 47.2% for the S&P 500 ETF (SPY) (see the details here). As you may notice the average annual outperformance of this strategy is more than 18 percentage points per year since August 2012. This result is very similar to what we observed in back tests.
6. So, should investors avoid hedge funds and invest in index funds? The answer is no. It is clear that it doesn’t make sense to invest in an average hedge fund. Most hedge funds take in more assets than they can manage profitably and abuse their dumb investors with sky high fees. It is also a fact that investors can’t generate any alpha by investing in index funds like SPY. Our research has shown that it is still possible to generate significant alpha in the small-cap space. The obvious decision is to ignore hedge funds’ large-cap picks and imitate their consensus small-cap picks. Hedge fund managers are smart people and they can outperform the market by large margins if they were managing a tiny fraction of their current assets. There are enough opportunities to manage tens of billions of dollars but there aren’t enough opportunities to manage $3 trillion profitably. Unfortunately they don’t want to turn away dumb investors and give up $120 billion a year in fees. It is also a fact that there are some hedge funds who still generate very respectable alphas pretty consistently. However, we find it more attactive to invest in hedge funds’ best ideas than investing in their all ideas.
