Alternative Investment Management Association Representing the global hedge fund industry
Hedge 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.
A newly-published study from the Centre for Hedge Fund Research at Imperial College, however, uses compelling, empirical data backed by detailed analysis to contribute some much-needed objectivity to the debate about the merits of hedge funds. The research, commissioned by KPMG, the international audit, tax and advisory firm, and AIMA, provides powerful proof of hedge funds’ ability to generate stronger returns than equities, bonds and commodities and to do so with lower volatility and risk than equities.
The research’s headline finding was that hedge funds achieved an average return of 9.07 percent from 1994–2011 after fees. That net return compared to 7.18 percent for stocks, 6.25 percent for bonds and 7.27 percent for commodities. The research also demonstrated that hedge funds were significant generators of “alpha”, creating an average of 4.19 percent per year from 1994–2011. And the paper, which included inactive as well as active funds, thereby preventing survivorship bias, found that an equal-weighted hedge fund index returned five times the initial investment after fees from 1994–2011.
But the researchers at Imperial College looked beyond simple performance. They found that hedge funds achieved those solid, long-term returns with considerably lower volatility and Value-at-Risk (VaR) than stocks and commodities, and similar volatility and VAR to bonds. Since hedge funds deliver over one-third higher average returns and significantly higher Sharpe ratio than global bonds, the researchers were able to conclude that hedge funds generate superior performance over conventional asset classes.
The researchers also considered the correlation between hedge funds and conventional asset classes over the business cycle. They found that hedge funds exhibit relatively low correlations with other asset classes. The average correlation between hedge funds and global stocks is 0.8, while hedge funds exhibit a negative correlation of -0.06 with global bonds and a positive correlation of 0.41 with commodities. Correlations between hedge funds and the main asset classes also were found to be only slightly higher during significant market downturns, which the report said suggested that hedge funds are unlikely to threaten the stability of the financial system. The study also showed explicitly that an equally weighted portfolio of hedge funds, global stocks and bonds outperforms the conventional 60/40 allocation to stocks and bonds with a significantly higher Sharpe ratio, lower tail risk and substantial diversification benefits.
We believe one of the researchers’ most significant findings related to how industry profits are shared between managers and investors. There has been a lot of debate around this issue lately. What the paper confirmed was that, out of an average gross return over 17 years of 12.61 percent, 9.07 percent went to the investor and 3.54 percent to the manager. Put another way, 72 percent of the profits went to the investor and 28 percent to the manager. This is a strong rebuttal to those who have suggested that the profit share may be the other way round. Yet it is the logical outcome based on a traditional “2&20” fee structure (or for the sake of accuracy, a 1.75 percent and 17.5 percent structure, which is closer to the average).
The study also looked beyond the impact of the industry on investors and weighed up questions including the value of the industry to markets and the broader economy. A review of academic literature concluded that hedge funds are important liquidity providers in the markets that they are active in, while hedge fund activity has beneficial effects for price discovery, the efficient allocation of capital, financial stability, shareholder value, portfolio diversification and the broader economy.
The researchers also reiterated a point that we have been stressing for some time, that the industry’s value can be measured in the fact that it is managing investments from organisations which might be regarded as “socially valuable” investors such as pension funds, university endowments, charities and insurance companies. The paper concluded that the ability of hedge funds to deliver superior risk-adjusted returns and better downside protection meant that the industry was playing an important social role as guardians of these investments.
The publication of this study comes during a momentous period for the industry. There has probably never been a time when there has been more interest in - and scrutiny of - the activities of hedge funds, whether by investors, policymakers, regulators or the media. Much of this is welcome and is in the long-term interests of the industry. Performance, fees and transparency have always been pivotal issues, but what is clear is that they have assumed even greater importance since the crisis.
By focusing on a time period of some 17 years, the researchers have been able to present an informed and balanced view. Despite a desire in some quarters to focus on ever shorter periods of performance, the real picture, as the study shows, is that hedge funds have been a very solid investment for a long time.
This article first appeared in Absolute Return magazine: www.absolutereturn-alpha.com
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