As debate of the merits of hedge funds as an attractive asset class for institutional investors continues, a new study has found their investment performance to be underwhelming.
The study by CEM Benchmarking, a Toronto-based global provider of investment cost and performance benchmarking for institutional investors, found more than two-thirds of the hedge-fund portfolios analyzed underperformed simple benchmarks. The average fund had a return of almost 1.9 per cent less than its comparable benchmark, the study found.
The study was based on a survey of about 30 of CEM’s top global clients as well as 15 years of CEM hedge-fund data comprising more than 300 funds.
Brad Kelly, a partner at Global Governance Advisors, a compensation advisory firm in Mississauga, Ont. that serves Toronto, Calgary, Miami and New York, is among the critics of hedge-fund investments in pension funds. He calls them “very expensive and not giving returns they’ve promised.”
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The study comes as some U.S. pension funds have announced they’re getting out of hedge funds. Recently, for example, the New York City Employees’ Retirement System said it was exiting its US$1.5-billion hedge-fund program, according to a report in the Financial Times.
The Canada Pension Plan Investment Board, meanwhile, has said it will remain active in hedge funds, according to the same Financial Times story.
“We closely monitor our [external fund managers’] performance and make adjustments when warranted, but we continue to be committed to our hedge fund program,” the Financial Times quoted Pierre Lavallée, senior managing director at the CPPIB, as saying.
When it comes to his criticisms, Kelly says hedge funds can’t provide the guaranteed returns pension funds need and cites the high costs paid to hedge-fund managers regardless of performance. “They’re paying so much money to external money managers. This is money going outside these public pensions, where if they were paid just a bit more, they [could] bring some decent talent in-house and use net savings towards other investments.
“Everyone is outraged if an exec is making a couple hundred thousand and yet these private hedge funds are making multiples of that and yet they’re not carrying the risk or liability or the management responsibility for it.”
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The CEM study found direct hedge funds — on the basis of base and performance fees — cost on average 2.31 per cent per year, while fund-of-fund hedge funds cost on average 3.56 per cent per year. By comparison, direct hedge funds underperformed the CEM benchmark by an average of 1.66 per cent versus 2.17 per cent for more expensive fund-of-funds with the difference mostly due to higher investment costs.
The benchmarks used in the study involved custom portfolios of stocks and bonds chosen to match the risk of each fund analyzed. Besides looking at fees, the study found a high correlation between hedge-fund returns and those of the corresponding stock-bond portfolios.
“I think the most surprising part of the study is just how much of the return of hedge funds can be replicated by simply holding a 50/50 stock/bond portfolio” said Alexander Beath, senior research analyst at CEM Benchmarking and lead author of the study.
“Hedge funds are often compared to equity indices, but this isn’t appropriate. The risk and correlations in hedge funds lies somewhere between stock and bonds, and so this is what they should be compared to.”