Hedge Funds – How good are they really?

Are High Hedge Funds Costs Justified by their Returns?

Commonly Unique

When it comes to hedge funds, the common perception is that they constitute high-cost, high-performance investment vehicles. The high cost element is certainly true, with the combination of management fees and performance fees in some funds even exceeding the raw return of some standard passive investment strategies. However, the high performance claim merits further investigation.

So, what does this combination of high fees actually buy you? According to the hedge fund themselves, what you get for your money is skills. More specifically, you get a skilled fund manager who can invest on your behalf in a way that you (or other sophisticated investors) could not. In this sense, the high fees that hedge funds charge are simply an appropriate compensation for pursuing unique investment strategies. These unique investment ideas will eventually earn returns that are high enough to more than make up for their high cost. Or so the story goes.

In a recent study with Ekaterina Panopoulou, we put this claim to the test. In particular, we rank hedge funds according to the distinctiveness, or uniqueness, of their investment strategies and then look at which funds tend to have the best performance. Even in an industry where all managers pride themselves on possessing unique skill sets, strategy distinctiveness is a continuum. Some funds indeed seem to invest in a very distinctive way (for better or worse), while others appear to be happy to stay somewhat closer to the herd. More importantly, if the argument about high fees-skills-performance is to be accepted, we would expect funds with more distinctive strategies to significantly outperform their more ‘plain vanilla’ peers.

A Risky Business

At a first glance, the returns that hedge funds offer to their investors provide some support for the industry’s mantra about unique skills leading to better performance. Funds that pursue unique strategies indeed seem to earn higher returns. However, returns are not the same thing as performance. After all, any high-risk asset would be expected to offer high returns on average, otherwise nobody would consider holding it. This does not necessarily make it a better investment, though. In order to claim that unique skills result in improved performance, we need to look at a fund’s risk-adjusted return (this is the return earned per unit of risk taken).
When the risks taken by hedge funds enter the equation, then the picture changes substantially. The relationship between strategy uniqueness and risk-adjusted returns is actually negative, and consistently so. In other words, skilled fund managers target high returns, but at the cost of accepting much higher levels of risk. Furthermore, the more skilled the fund manager is, the worse the risk-return trade-off.

Safety in Numbers

Overall, it could be the case that hedge fund managers are consciously more interested in reporting high raw returns, even if they have to load excessively on risk to do that, rather than trying to achieve better risk-adjusted performance.

One possible reason for this can be found in the option-like characteristics of managers’ compensation contracts. From the manager’s point of view, an ever-increasing level of risk could make perfect sense. This is because of the upside of large gains, leading to high performance fees, is likely to outweigh the downside of large losses (after all, any level of losses at year-end would lead exactly to the same performance fee, namely zero). This potential explanation is strongly supported by the empirical finding that hedge funds with very distinctive investment strategies tend to take on substantially higher levels of downside risk in particular.

The conventional wisdom that highly skilled hedge fund managers charge very high fees because they deliver superior performance needs to be constantly challenged and evaluated against the evidence. As it stands at the moment, it seems that the performance of high-end hedge funds that pursue very unique strategies does not seem to justify the double cost of high fees and high risk. Perhaps the ‘boring’ lower-cost funds that tend to follow the herd are a better option.

Dr Nikolaos Voukelatos is currently a Lecturer in Finance at Kent Business School and part of the Centre for Quantitative Finance Research (CEQUFIN). His research interests fall under the general area of financial econometrics; in particular, his work focuses on extracting risk-neutral densities from option prices, the efficiency of options markets, forecasting, and conditional variance models.

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