Understanding hedge fund performance better

Mon Jun 9, 2014

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It is all too common today for comparisons between aggregated hedge fund indices and equity indices like the S&P 500 to be made


By Jack Inglis, CEO, AIMA

 
  Jack Inglis
It is a debate possibly as old as the hedge fund industry itself. Investors, commentators and the media have long mulled over how to understand hedge fund performance and compare it to other investments. But since the financial crisis, and the quantitative easing-fuelled boom in public equity markets that followed it, these debates have intensified.

It is all too common today for comparisons between aggregated hedge fund indices and equity indices like the S&P 500 to be made. For example, a set of monthly hedge fund index figures is often compared to the S&P 500 in that period with the latter used as a proxy for the 'market', with the difference between the two interpreted as hedge funds either under-performing or over-performing 'the market'.

This of course is not the way most institutional hedge fund investors or funds of hedge funds measure the performance of their allocations. They may have a particular return figure in mind for the hedge fund part of their portfolio - the 'risk-free' rate plus x, say - or be seeking to lower volatility or provide downside protection. They are not generally looking at their hedge fund allocations and thinking, "we must beat the S&P 500". Just as there are many different types of hedge funds, so there are many different things that investors are seeking from their hedge fund allocations.

Indeed, it is striking that recent surveys have highlighted high levels of investor satisfaction in hedge funds at a time when many commentators have claimed that the industry is being out-performed by the market. The reason for this is that investors are not allocating to hedge funds to beat the S&P 500, but to allow them to meet their asset-liability management objectives in terms of risk-adjusted returns, diversification, lower correlations, lower volatility and downside protection.

But some prospective investors or non-investment specialists (such as pension fund trustees) may not intuitively think like this. They may look at hedge fund returns and think it appropriate to compare them to the S&P, FTSE 100, MSCI World or another equities index.

That is why we hope that our new paper, 'Apples and Apples: How to better understand hedge fund performance', is so timely. As the title suggests, we believe that comparing hedge fund returns to the S&P can be an 'Apples and Oranges' comparison, and that it is better to do the following:

1. Look at risk-adjusted returns: the paper confirms that hedge funds as a whole consistently outperform US equities (as measured by the S&P 500), global equities (MSCI World) and global bonds (Barclays Global Aggregate ex-USD Index) on a risk-adjusted basis, a measure that is highly valued by investors. Even during the stock-market rally of recent years, hedge funds performed better on a risk-adjusted basis than the S&P 500 and MSCI World (with a Sharpe ratio of 1.28 versus 0.95 for the S&P 500, based on the HFRI Fund Weighted Composite).

2. Look at long-term data: the stock market rally of recent years may not last forever. Even taking the index data, hedge funds have outperformed the main standalone asset classes over the last 10 years with a cumulative net return of 74%.

3. Look at the returns by strategy: hedge fund strategies are very diverse and often behave very differently to each other. Putting them all in one bucket and saying that it represents the performance of the 'average' hedge fund can be misleading.

4. Compare with the most relevant asset class, not just equities: when benchmarking hedge fund performance, reference should be made to how different strategies perform in relation to the most relevant asset class, whether fixed income, commodities or equities.

5. Be aware of differences between the indices: in the five years to the end of 2013, the main hedge fund indices produced notably different results, reflecting variations in constituency and methodology.

6. Remember investors do not make either/or choices between equities and hedge funds: investors allocate to hedge funds as a complement to their equities, not instead of them. They will often want different things from their hedge fund allocations and their equities allocations.

7. Consider how investors use hedge funds: investors use alternatives in general and hedge funds in particular as tools to customise their portfolios. Allocating to hedge funds allows them to meet individual and more customised asset-liability management objectives in terms of risk-adjusted returns, diversification, lower correlations, lower volatility and downside protection. This may explain the high levels of investor satisfaction from their hedge fund allocations that many surveys have reported, even at a time when many commentators have been arguing that the industry 'under-performed' relative to the S&P 500. It suggests that many institutional investors may prefer steadier returns achieved with lower volatility to higher returns achieved with greater volatility.

Put simply, many investors value getting steadier returns with lower volatility over higher returns with much greater volatility. As our paper shows, hedge funds actually have lower volatility not only than equities but also bonds. What that means is that in terms of the risk taken - that is, in risk-adjusted terms - the industry continues to out-perform.  

  


ISSN: 2151-1845 / CDC10004H