(CityWire USA) - What happened in 2008?
Well, yes, the global economy suffered a crippling financial crisis that brought capitalism to its knees. But more specifically, what happened around 2008 that turned hedge fund heroes into zeros?
The question is taken up by finance academics Nicolas Bollen, Juha Joenväärä, and Mikko Kauppila in a paper called ‘Hedge Fund Performance: End of an Era?,’ which was recently published in the CFA Institute’s Financial Analysts Journal.
The authors begin by measuring hedge fund performance in a variety of ways.
Comparing overall hedge fund performance to the returns generated by a 50/50 stocks-and-bonds portfolio, they found that from 2000 to 2008, hedge funds generated a total return of about 225% compared with 125% for the stocks and bonds. This is followed by a ‘dramatic reversal,’ wrote Bollen, Joenväärä and Kauppila. ‘The two return series track each other quite closely during the financial crisis years, but starting in mid-2011, they diverge, with the hedge funds delivering about 25% total return, versus 70% for the stock/bond portfolio.’
A different framing makes the same point. The authors found that ‘approximately 20% of [hedge] funds delivered significant positive alpha until about 2008, when the fraction dropped roughly in half.’ Meanwhile, up until 2011, 5% of the funds had the dubious distinction of providing ‘significant negative alpha’; after 2011, the ranks of this ignominious group frequently swelled to 20%.
Of course, it’s the rare investor who goes all-in on hedge funds. So to look at the effects of allocating a portion of one’s portfolio to hedge funds, the authors examined portfolios that include a 20% allocation to a basket of randomly selected hedge funds.
The results here were slightly more encouraging. The authors found that even in the disappointing 2008 to 2016 period, a portfolio that included a 20% allocation to hedge funds performed no worse from a risk-adjusted basis. That’s because these hedge-inclusive portfolios generated reduced volatility to go along with their lower returns.
Finding the culprit
So why did performance fall off a cliff in 2008? The authors considered a few theories.
One idea is that significant stimulative actions by central banks such as the Federal Reserve changed markets. By exerting an overwhelming influence on capital markets, the Fed’s actions may have had the side effect of increasing correlations among assets. This matters because in a higher-correlation environment, selections become less important, so skilled investors generate relatively less value. And indeed, the authors did find that correlations rose meaningfully around 2008 and stayed particularly elevated through 2013.
Another theory is that greater regulation hurt returns. Internal compliance costs rose, but perhaps more importantly, ‘the increased regulation could have a chilling effect on insider trading and other trading violations, which would reduce actual fund performance’. Further, a sneakier source of high observed hedge fund returns – misreporting of performance – also appears to have been tamped down. Since performance decreased further after the passage of Dodd-Frank in 2010, the authors said these ideas are also backed up.
The idea that greater competition among hedge funds hurt performance received ‘mixed support,’ based on the data. Finally, turning to an issue presumably near to the hearts of academics who write about hedge fund strategies, Bollen et al found that ‘the publication of research describing successful strategies’ utilized by hedge funds ‘is probably not relevant’.
What does it all mean for allocators? The authors write that unless central banks step back from stimulative policies or regulators start turning a blind eye to hedge fund misconduct, ‘hedge funds in aggregate may not be able to achieve the same level of success going forward that fueled their rise in the mid-1990s and sustained them to the mid-2000s’.
However, Bollen, Joenväärä and Kauppila do begrudgingly grant that since hedge funds do appear to generate some diversification benefits, ‘more risk-averse investors can continue to justify a modest allocation to such alternatives’.
