Hedge funds continue to grow in popularity in the face of bare statistics illustrating their failings

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We can only be delighted with the conclusions of the latest research conducted by Citi about the hedge fund industry (http://www.citibank.com/icg/global_markets/prime_finance/docs/Opportunities_and_Challenges_for_Hedge_Funds_in_the_Coming_Era_of_Optimization.pdf). They predict a new era of optimism with the hedge fund industry almost doubling in size byl 2018 as sophisticated investors continue directing their funds into the so called “smart money” industry, looking for the downside protection that hedge funds are supposed to offer.

It is true that hedge funds sometimes just can’t beat the market, but, say the proponents of the industry, that is the price an investor should pay for the downside protection they receive with these funds, as hedge fund should offer them a hedge against market downturns and crashes. Does it sound good to you? Of course not! Neither does it to us! With the exception of an increasingly rarified few hedge funds, as an industry they spectacularly failed to predict the global financial crisis and so thus failed at protecting investors’ money. This reason alone is also why after 2009 many of them turned into what is called “family businesses” and many others just ceased to exist as a tide of withdrawals swept in after investors realised that the promised alpha was just a mirage. With commissions on profits surpassing 20% at some funds, and with downside protection being seemingly nonexistent, investors finally twigged that they could do much better by investing in an S&P 500 passive ETF or even through simly adding overseas shares and bonds to their portfolio to reduce  risk.

The latest financial crisis, like many others before it, has showed us once again that professional managers aren’t able to effectively reduce risk because the correlations between the assets within a portfolio are much larger than at first thought. This means that investors are doomed to take a real drawdown when the market tanks because they are not effectively protected for such an event either through their own asset allocation or their fund manager’s skill.

In spite of these glaring failings, an interview carried out by Citi with industry professionals ranging from asset managers, to beneficial owners, consultants, endowments and many other institutional investors involved in the hedge fund industry highlighted the positive expectations that even the professionals continue to have, all pointing to downside protection as the main reason to accept lower returns during upturns. Indeed, according to Citi, the prospects for the hedge fund industry look evenbetter than ever, with investors now splitting their funds across several hedge fund products rather than the mutual funds they did in the past and other investment vehicles. The picture they paint is so vivid and bright that we need sunglasses to look at it properly!

Academic research, as well as many industry reports, shows at best mixed results for collective hedge fund performance. Just to point out one example, KPMG conducted a study on the performance of hedge funds between 1994 and 2011 and found that the hedge fund industry averaged a 9% annual return during the period. They highlight the fact that between 2007 and 2011 the funds averaged 2%, as the losses between 2007 and 2009 were huge. This kind of performance isn’t any better than the market, unless you could say the risk involved is lower – but you can’t! Hedge funds show lower risk-adjusted returns than the market as a whole, meaning that the only reason why they outperform the market when the market rises is because they don’t really “hedge” but rather “lever” their positions, and which also explains the poor performance during bear markets. Alternatively put, they just make use of a “higher beta”, which means a higher exposure to systematic (or market) risk due their borrowing capability.

So, with all this in mind, we ask ourselves once again, why are hedge funds rising in popularity? It certainly isn’t because of any alpha but rather we suspect because of continued superlow interest rates. The persistence of low interest rates sponsored by the Federal Reserve is creating severe difficulties for all those investors and fund managers who traditionally applied funds into low beta assets. When interest rates decrease, investors need to put aside more funds to get the same benefits in the future.

Let’s suppose the interest rate is 5%. The present value of £100,000 in 20 year time is £37,689. But if the interest rate decreases to 0.25%, the present value is then £95,129. This means that in order to get the same value in 20 years’ time, you now need much more funds or, put differently, the contributions you need to make for your pension need to be much higher. Now think of the pressure all those pension and endowment funds feel from low interets rates. They need to find a way of counter-balancing the huge liability created by the low interest rate, so they desperately shift investment from lower to higher risk, and that is the main reason why hedge funds are growing. The Federal Reserve is shifting risk perceptions. Ergo the growth experienced by hedge funds rather than representing an opportunity as Citi reports it, is a warning sign of future disaster.

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