2009 hedge fund performance–a bad year following an unusual one

Up 19% over the past year, according to the FT

The Financial Times published an article early on December 31st proclaiming that hedge funds produced gains of 19% for investors in 2009.

How could they know so soon?

My first thought was, How could anyone know this, with one trading day still to go before yearend?   So I checked the referenced Hedge Fund Research website and found that the 19% figure is performance is actually for the twelve months ending November 30, 2009.  Other sites show performance as somewhat lower.

Way under the S&P

In all cases, though, performance was way below the 25%+ return an S&P 500 index fund would have achieved over the same time span.  In the relative performance world, losing over 600 basis points to the index in a year is really bad. It would mean at the very least no bonus and could easily result in your being fired.

The 2009 numbers reinforced my view–which I still hold–that hedge funds are by and large a marketing phenomenon, the successor to oil and gas or real estate limited partnerships.  They feed the egos of the buyers by establishing that they’re wealthy enough to “need” the product, while delivering net returns that are inferior to more prosaic vehicles like stock and bond index funds.  Their leading characteristic is that they generate huge fees for the product promoters.

Look at 2008, though!

Then I looked at the 2008 hedge fund numbers.

Hedge fund performance aggregators show average results for 2008 that range from -15% to -18%, depending on the source.  This compares with -38% for the S&P 500 and -13% for an indexed balanced fund (a fund indexed 60% each to large-cap US stocks and 40% to long-term Treasury bonds).

How could relative performance have been this good vs. stocks?  How could a simple balanced fund–devoid of exotic trading strategies (and high fees) have done better?

Twists and turns

Hedge fund performance may not have been quite so good as advertised, for one thing.  There are several complicating factors in 2008 results, namely:

survivor bias. 700 hedge funds, or about 10% of the worldwide total, went out of business in 2008.  That’s a BIG percentage. They were presumably not the best performers.  So by default the survivors look a bit better.

withdrawals not allowed. Unlike mutual funds or ETFs, hedge funds are able to–and in 2008 did on a widespread basis–decline investor requests to return their money.  This reduced downward pressure on any illiquid holdings of the hedge funds.  At the same time, it probably put additional negative pressure on non-hedge fund assets, which would an owner would, by default, be forced to sell if he needed to raise cash.

pricing issues. A recent NYU academic study covering about 10% of the industry, commissioned by a hedge fund due diligence firm, found that 28% of the hedge funds analyzed provided incorrect or unverifiable information about investment performance, assets under management or other investment issues.  In a fifth of the cases, managers lied in face-to-face interviews about investment performance, assets under management or their education or experience, even though they knew the interviewers were going to check all the information given (see my post Are hedge funds honest?:  an NYU study for details).

This raises the question of whether some hedge funds used “creative” pricing techniques to ascribe a high value to illiquid assets, in the same way that the big commercial and investment banks did–thereby overstating their investment results.

Customers were not happy

You might guess that the questions raised above mean the actual performance of hedge funds in 2008 was closer to -20% to -22% than the -15% to -18% reported.  But even that is still a mile better than the -38% the S&P achieved, a distance so large that it indicates a significant performance differential, absent Bernie Madoff-style accounting.

In relative performance-land, -22% would make you, if not exactly a hero, at least a top-level performer.  Why, then, have hedge fund customers been unhappy?

My thoughts as to why

I have several guesses, but–not being an institutional hedge fund customer–I honestly don’t know.  Here’s what I think:

1.  Clients knew intellectually that hedge fund managers might freeze redemptions, but really didn’t believe it would ever happen.  Purchasers underestimated the illiquidity of hedge fund holdings and may have mischaracterized them to their bosses.

2.  They really believed the credo of absolute performance–that in a down year for other asset classes, hedge funds wouldn’t lose money.  If your expectation is + something, -15% looks really ugly.

3.  In the same vein, clients who invested in hedge funds in 2003 experienced a string of years of underperforming an S&P index fund.  I can almost hear the hedge fund marketers saying that the big payoff from holding on would come in the inevitable down year for the stock market.  After all, that’s what happened in 2001-2002.

Well, the down year came and, with it, significant outperformance of the S&P.  But maybe it was only enough to offset the underperformance of the prior five years.  And in 2009 underperformance resumed.  If it walks like a low-beta stock fund and quacks like one, too, what makes it a hedge fund, other than the fee structure?

4.  Clients could have achieved hedge fund results, or maybe better, in 2008 with a more prudent allocation among asset classes.

Where to from here?

Anecdotal evidence suggests that assets under management in the hedge fund industry have stabilized and net inflows are beginning again for the first time in two years.  Hedge Fund Research indicates this as well.

The MAN Group, a publicly-traded hedge fund group (whose statements I think are therefore more reliable than those of the industry in general) said in November that withdrawals from Europe were being partially offset in the first half by new money coming in from the Middle East and Asia.

Barclays Capital, in a news release filled with corporate-speak from its prime brokerage division, emphasizes it’s being told by its hedge fund customers about gross inflows, but is not clear about the net situation.  It does say that the sales cycle is taking longer, as potential investors require a clearer explanation of exactly what a given hedge fund manager does. In addition to being better informed before turning over their assets, Barclay’s seems to indicate that clients are redirecting money away from smaller hedge funds (where in the past most of the very good returns have been achieved) toward their larger, more established rivals.

It will be interesting to see how fully the hedge fund industry will be able to recover from its long period of not-as-promised performance, and the scandals like that of Madoff and Galleon that have emerged during the financial markets collapse.

There are powerful constituencies in the hedge fund corner.  Wall Street now depends heavily on hedge fund trading revenues; its margin borrowing is the life-blood of the brokers’ prime brokerage arms.

More important from the pension fund perspective, though, hedge fund consulting is the latest offshoot of the pension fund consulting business, which derives very large income from being hired (as a kind of risk-shifting away from the pension plans themselves) to perform the pension plans’ task of creating an asset allocation plan, and analyzing and selecting specialist managers to implement it.  Consultants ply their trade among asset managers, as well, advising them on how to make themselves appealing to pension clients.  Here, at least from a short-term point of view, it’s in all the players’ economic interests to have increasingly complex and specialized products to ponder, since these allow maximum risk-shifting and generate maximum fees.

On the other hand, the fact that hedge funds in general don’t perform as advertised is a powerful force in the other direction.

We’ll see.

Leave a Reply

%d bloggers like this: