Hedge funds aren’t cheap either. The median fee structure according to the TASS Database is a 1.5% management fee plus a 20% incentive fee, where managers are paid 20% of all returns that are above their target benchmark. So, one must ask: are investors getting their money’s worth?
It’s difficult to tell. Despite the growing mainstream use of hedge funds, the industry is largely unregulated because hedge funds are usually either limited partnerships or off-shore corporations. This gives hedge fund managers tremendous flexibility, but makes accurate measurement of performance difficult.
Hedge funds are not required to report their returns and so those that are large and performing extremely well may not want or need to attract any more money and may opt not to report. On the other end of the spectrum, those that have poor performance may not want to report.
The two main biases that pump up hedge fund returns are survivorship and backfill. When a hedge fund fails, the fund—and its poor performance history— is frequently removed from the index. This leaves an artificially inflated index of solely successful surviving funds. Backfill refers to hedge funds waiting for a period of good performance before joining an index, since they have to report in order to join one.
Analyzing the after-fee performance of about 3,000 hedge funds in the TASS database from January 1995 to April 2006 reveals insights into true hedge fund returns. An equally weighted index of hedge funds was used in the analysis to make sure the more successful large hedge funds did not have a disproportionate impact on the indices’ overall returns. The average annual return is 16.64% after fees. Correcting for survivorship bias and backfill bias and adding the performance of failed(or dead)funds back into the index, the return dropped to 13.9%. Upon elimination of backfill returns, the average annual return declined to 9.06%.
In the analysis, large hedge funds tended to produce larger returns than small hedge funds. For example, the largest 1% of hedge funds in the TASS universe had average annual returns of 12.94%, and the largest 5% of hedge funds produced returns of 10.53%. The smallest 50% of the universe, however, posted returns of 8.67%. While that 9.06% return after adjusting for survivorship and backfill biases may not seem so exciting given the comparable return on stocks over the same time period, hedge funds bring good diversification to a portfolio of traditional investments. The 9.06% return figure for hedge funds after correcting for bias and weighting can be broken down into two components: alpha(3.7%)and beta(5.4). Since manager fees are estimated to average 3.8%—about the same as the alpha—the investor and the manager roughly share the excess returns.
Reference
“Sources of Hedge Fund Returns: Alpha, Beta, and Costs”, Roger Ibbotson and Peng Chen, Yale School of Management Working Paper, 2006
Peng Chen is the president and chief investment officer of Ibbotson Associates
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