Do Hedge Funds Really Work?

story_images_domino-tilesIt’s a recurring theme in the popular press that “banksters” should never have been bailed because it’s caused wrack and ruin amongst the populace whilst protecting speculation gone bad.

How well does this square with reality? First, the banks that were bailed out were bailed out for improvident loans to impecunious consumers now complaining of wrack and ruin. That they were badly hedged against that risk is certainly a problem and of course some banks were going to founder on their “speculative” loans, because the consumers had no money to pay them back. As the song goes, “who’s bailing whom.”

It’s not a neat circle – more like a contorted ellipse. The one side points to an overly remunerated banker; the other to someone’s aspirations that far exceeded her ability to pay. Little attention is given to what happens when liquidity dries up, and your bank, your employer and your dog-walking park close down because there’s no cash flow.

In this instance, government is both blamed yet sought as the backstop. Thus, as one newspaper writer put it, banks should be nationalized to prevent “speculators” driving a country into wrack and ruin. Who are the speculators? No one names names, but likely private funds willing to fund a government’s refinancing of its debt after it has proven dismally bad at raising taxes or managing expenses. After all, institutional funds are not  prepared to bear the risk and then have to cry over Argentina at the next board meeting. So it’s a last chance bet … not unlike the mortgage lending that, in the final analysis, brought the world to its financial knees in the first place.

Still, in the complaisant world of quasi-karma that the wracked and ruined inhabit – or at least their advocates —  the assumption is that it must be banksters who are at fault, not debt-laden auto manufacturers, nor overleveraged homeowners who emphasized return over risk. No, instead the trope is that banksters have been speculating on other people’s failure.

New research, “The value of the hedge fund industry to investors, markets, and the broader economy,” published  by KPMG and the Alternative Investment Management Association suggests otherwise. Research compiled by London-based Imperial College’s Centre for Hedge Fund Research, notes that “[h]edge funds, their role within financial markets and the returns they generate have been under considerable debate since the global financial crisis. Some policymakers have been quick to blame hedge funds for market failures, while some critics have questioned their performance.”

The study dismantles a number of nouveau urban legends. Of course, that requires facts – and attribution analysis. “[O]ur performance analysis,” the Imperial College researchers aver, “shows that hedge funds have significantly outperformed equities, bonds and commodities on a risk-adjusted basis. The research found that hedge funds achieved an average return of 9.07 percent in the period 1994–2011 after fees compared to 7.18 percent for stocks, 6.25 percent for bonds and 7.27 percent for commodities. Hedge funds achieved these returns with considerably lower volatility and Value-at-Risk (VaR) than stocks and commodities, close to bonds in both categories. The research also demonstrated that hedge funds were significant generators of ‘alpha,” creating an average of 4.19 percent per year from 1994–2011.”

How much of this alpha did investors see, given that “banksters” or is it rather “hedgesters” are more concerned, according to popular tales, with aggregating assets to earn fees. The Imperial College study  indicates that “investors received approximately 72 percent of all investment profits over this period, compared to 28 percent for hedge fund managers.”

But the key question is whether it was worth it: did investors get alpha by forsaking pure beta? On this score, there are a number of levels of analysis: Sharpe ratios, volatility and the holy grail – diversification.  Says the Imperial College study:

“An examination of the alpha generated by hedge funds suggests that they provide superior performance, even on a risk-adjusted basis. Our findings suggest that hedge funds provide significant diversification benefits, since they have low correlations with conventional asset classes over business cycles. As Markowitz (1952) showed in his seminal paper, investors can obtain steadier returns by combining assets with roughly similar expected returns but low correlations in the same portfolio. In particular, hedge fund strategies such as CTA, macro and market neutral have a low correlation with the main conventional asset classes, on average, and even during recessions. Using equal-weighted hedge fund index data from 1994 to 2011, we demonstrate that an equal weighted allocation to hedge funds, stocks and bonds delivers significantly higher Sharpe ratio and lower tail risk than the institutional investor’s standard 60/40 allocation in stocks and bonds. Overall, the results suggest that hedge funds deliver superior risk-adjusted performance and provide diversification benefits over the business cycles and even during recessions.”

Correlations may indeed go to one in times of crisis. So can criticisms. The key to successful investing is to ignore the noise of the crowd, it seems. Particularly anecdotes of wrack and ruin.