Hedge Funds Have Done Well Despite Negative Publicity

One reason some people think hedge funds have not done well since 2009 is because the qualitative easing-induced rally in equities started after a 55% drawdown while hedge funds as a group did not fall that much. Those that do not do the math fall victims of negative publicity and dubious narratives.

Before we start let us make some things clear about what this article is not about:

  1. The article is not about the return a random investor in a random hedge fund would have realized.
  2. The article is not about hedge fund returns net of fees and taxes but about hedge funds manager skill to outperform the S&P 500 total return.
  3. This article is not about specific fundamental and technical methods hedge funds employ and whether they are profitable or not.

Regarding the data used:

I have used data from BarclayHedge. The data reflect net returns of reporting funds. The Hedge Fund Index more recent reports were based on data from 3077 hedge funds. The Long/Short Equity Hedge Fund Index more recent reports were based on 389 funds. There has been attrition, which is an argument brought against the validity of theses indices. Although this is true here are some counter-arguments:

  • There is also attrition in S&P 500 index. Actually, this index is a trading strategy that buys and sells stocks based on some criteria.
  • Hedge fund attrition impact can be considered positive bias in the same sense that S&P 500 rebalancing generates a positive bias. No attempt is made here to compare the size of these two effects.
  • Usually hedge funds that blow up are of small size. Note that the results of the performance of hedge funds are not capitalization weighted as it is the case with the S&P 500.

Below is a graph of the growth of $1 for the index of all hedge funds, long/short equity hedge funds and S&P 500 TR since 1997 based on yearly net return data from BarclayHedge:

Data source: BarclayHedge www.barclayhedge.com

It may be seen from the above results that Long/Short Equity hedge funds have outperformed All Hedge Funds and also the S&P 500 TR. Below are some key metrics.

Index Drawdown CAGR SHARPE MAR
SP500TR -37.5% 7.05% 0.41 0.19
Long/Short Hedge Funds -11.4% 8.17% 0.73 0.69
All Hedge Funds -21.6% 7.94% 0.73 0.37

Table 1. Performance based on yearly net return data from 01/1997 to 12/2017

However, from 01/2010 to 12/2017, the picture in Table 1 changes:

Index Drawdown CAGR SHARPE MAR
SP500TR -1% 13.6% 1.96 12.9
Long/Short Hedge Funds -4.6% 4.64% 0.92 1.00
All Hedge Funds -4.6% 4.70% 0.92 1.02

Table 2. Performance based on yearly net return data from 01/2010 to 12/2017

Obviously, hedge funds grossly underperformed S&P 500 total return during in last 8 years. However,

  • The objective of hedge funds is not to outperform equity indices although at times some managers may wrongly refer to that as their aim.
  • The objective of hedge funds is to realize superior risk-adjusted returns and they have been successful in achieving that in the past when equity markets were in turmoil but there was no central bank intervention.

The main reason that S&P 500 TR appears to outperform in Table 2 is because of a lower starting point due to a significant drawdown in 2008. But many passive investors sold after hitting uncle point and they did not realize the high returns afterwards.

Central banks have paralyzed traders with continuous invalidation of technical and fundamental signals using quantitative easing and asset purchases as a weapon to engineer an asset bubble contrary to the principles of free markets operation. The idea that if all investors are passive this is good for the economy dominated with attacks directed towards traders and hedge funds.

The current divergence of equity markets from free market path is so wide that any black swan could cause a major disaster. “Do nothing” managers and passive index funds hope that central banks will be there to buy equities and other assets to keep the uptrends going. But this is wishful thinking. Long/short equity hedge funds have the higher probability of surviving market turmoil (assuming orderly markets and availability of names to short) while passive investors may face substantial losses and even hit uncle point.

The policies of central banks have penalized traders, hedge funds managers, savings and in general hard work in favor of lazy “do nothing” because that served multiple political and geopolitical goals. But all theatrical performances come to an end at some point otherwise the audience starts departing tired of the same narrative.

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2 Responses to Hedge Funds Have Done Well Despite Negative Publicity

  1. Drew Wells says:

    You say that the article is not about returns net of fees and taxes, but you report "net returns". What are the returns net of?

    • Hello Drew,

      Returns are net of fees charged to customers. We do not report the returns, BarclayHedge does. Also we only use the returns to study hedge funds average returns as compared to S&P 500 total return and not to recommend these as investments.

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