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Hedge funds: a bad choice for most long-term investors?

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Hedge Funds Ennis Scaled.jpg

Hedge funds have become an essential part of institutional portfolio management, accounting for around 7% of public pension assets and 18% of large endowment assets. But are hedge funds beneficial for most institutional investors?

To answer this question, we consider net-of-fee performance and its fit with institutional investors’ long-term investment objectives. We find that hedge funds have been in an alpha-negative, beta-light state since the Global Financial Crisis (GFC). Moreover, by allocating to a diversified pool of hedge funds, many institutional investors have unwittingly reduced their equity holdings.

So my answer is no, hedge funds are not profitable for most institutional investors. But I suggest some targeted approaches that might justify investing in small amounts. And I cite new research that shows the merits of hedge fund investing remain a matter of debate among academics.

Performance after fees

Hedge fund managers typically charge 2% of assets under management (AUM) and 20% of profits as fees. According to Ben-David et al. (2023), hedge funds’ “2-and-20” fee structures amount to more than “2-and-20.” Ben-David and his co-authors estimate the effective incentive rate to be 50%, which is 2.5 times the nominal 20%.

“This occurs because roughly 60 percent of the gains subject to incentive fees are ultimately offset by losses,” the authors say.1 They calculate the average annual cost of AUM for the hedge fund industry to be 3.44% from 1995 to 2016. That’s a heavy burden for what is essentially a portfolio of publicly traded securities. How did the funds perform?

Hedge funds performed well before the global financial crisis, but things have changed since then. Cliff Asness Hedge funds Gasoline has run outThis is probably because hedge fund assets grew tenfold between 2000 and 2007.2 This is likely due to changes in accounting rules that went into effect in 2008 regarding the valuation of partnership assets.3 And perhaps the increased regulatory oversight brought about by the 2010 Dodd-Frank reforms “cooled off some of the more profitable hedge fund trades.”Four

Either way, diversified hedge fund investing appears to be underperforming expectations in the modern (post-Global Financial Crisis) era. Over the 15-year period ending June 30, 2023, the HFR Fund Weighted Aggregate Index returned 4.0% annualized. This compares to a 4.5% return for a public market index blend that is 52% stocks and 48% Treasuries, a blend matched for market exposure and risk.Five By this measure, the hedge fund composite’s performance declined 0.5% for the year.6

However, the recent academic literature on hedge fund performance is mixed. Sullivan (2021) reports that hedge fund alpha began to decline after the global financial crisis. Bollen et al. (2021) reach a similar conclusion. On the other hand, a recent paper by Barth et al. (2023) shows that a new subset of hedge funds not included in the vendor database generates better returns than hedge funds not included in the vendor database. do Join the database.

The reasons for this are not entirely clear, but the discovery of these previously overlooked funds calls for further research and opens up room for academic debate on the merits of hedge fund investing.

Impact on hedge fund alpha

Our research focuses on how alternative asset classes, such as hedge funds, affected the alpha earned by the portfolios of institutional investors we study. The approach is concrete and practical: we calculate the alpha for a large sample of pension funds. We then determine the sensitivity of alpha generation across funds to small changes in percentage allocation to asset classes. Here, we observe the impact of each fund’s allocation to hedge funds on returns and the impact on hedge fund performance. Them The impact of hedge funds on financial institutions’ profits. There are no ambiguities or hypothetical elements in this procedure.

For each pension fund, the average allocation to hedge funds during the study period was obtained from the table below. Public Planning Data A resource from the Boston University Center for Retirement Research. While some pension funds in the database allocated 0% to hedge funds, the average allocation was 7.3%, and the maximum average allocation was 24.4%.

Figure 1 shows the results of regressing alpha on the allocation percentage of each hedge fund. The slope coefficient is -0.0759. tThe -statistic is -3.3, indicating a statistically significant relationship. The slope coefficient can be interpreted as follows: A 7.6 bps decrease in total pension fund alpha occurs for every 1 percentage point increase in hedge fund allocations.

Figure 1. Pension fund alpha vs. hedge fund allocations (2009-2021)

Hedge funds are a bad choice

Summary so far: Hedge funds are diversified portfolios of publicly traded securities. They can be costly to investors, recently estimated at 3.4% of AUM per year. Using HFR data, we estimate that since the Global Financial Crisis, hedge funds have underperformed benchmarks matched for market exposure and risk by 0.5% per year.

The academic literature on hedge fund performance is mixed. Our assessment of the impact of hedge fund investments on public pension fund performance since the Global Financial Crisis shows that an average allocation of about 7% of assets resulted in an alpha loss of about 50 bps per year across funds. Overall, these results call into question the wisdom of investing in hedge funds as a source of added value (at least in the case of diversification).

Hedge funds are not a proxy for stocks

Institutional investors have steadily increased their exposure to equities over time. Public pension funds’ exposure to equities has risen from 40-50% in 1980 to more than 70%. Large funds’ substantial exposure to equities has risen to 80-85% in recent years. Institutional investors are convinced that equities are key to long-term growth. More recently, these investors have been attracted to the added value potential of hedge funds. But aside from their potential as active investors, are hedge funds really right for them?

Asness (2018) provides anecdotal evidence of common misconceptions about hedge funds. He argues that by comparing hedge fund performance to stock indexes such as the S&P 500, people tend to think of hedge funds as a substitute for common stocks. However, he reports that hedge funds typically hedge equities and have less than 50% equity exposure. Thus, hedge fund betas are typically much lower than 1.0. Some hedge funds aim to keep their beta at zero as much as possible.

Thus, by substituting hedge funds for stocks, investors unwittingly Reduce Equity Exposure shows the correlation between a pension fund’s equity exposure and its allocation to hedge funds. Exhibit 2 shows the relationship between net equity exposure and allocation to hedge funds for a sample of 54 public funds. The intercept is a highly statistically significant 72.9% equity. A 1.6 percentage point lower equity allocation is associated with a 7.3 percentage point lower hedge fund allocation than the pension fund average. ( tThe slope coefficient statistic is -2.2, indicating that it is statistically significant.

In other words, public pension funds with large allocations to hedge funds tend to have lower effective equity allocations and may therefore unconsciously limit their exposure to the stock market.

Figure 2. Relationship between equity exposure and hedge fund allocation

Hedge Fund Image 2

Now, if hedge funds have the outsized potential to add active returns, gaining additional equity exposure elsewhere may make an allocation to hedge funds tolerable.8 However, we believe there is a lack of compelling evidence of alpha contribution. As a result, hedge funds with low equity betas may not be particularly suitable for most long-term investors.

Avoiding the asset class fallacy

We believe that some hedge fund managers are exceptionally talented, although rare. Identifying them and profiting from their skills is another matter. But we do not deny that exceptional managers exist. A big problem for institutional investors is the tendency to over-diversify in any type of active investment, and hedge funds are no exception. Let’s say that institutional investors believe they can identify at least a few great managers. How do we proceed?

First, as they build their efforts, investors should focus on the following: managerIt’s not an asset class, it’s an asset class. There’s nothing to be gained by saying, “I’m going to invest X% of my assets in hedge funds.” The Asset Class Fallacy The nature of hedge fund investing. Picking a successful hedge fund sounds routine, but it’s not. In our judgment, class There are few or no assets to offer. Allocations to hedge funds should increase or decrease depending on the opportunities recognized in a particular fund.

Second, we recommend limiting the total number of hedge funds to no more than about three or four, so as not to crush the talent of the best managers.Figure 3 shows the diversification of active risk that results from using multiple managers.9 Using four managers instead of one cuts active risk in half. Further diversification of managers reduces risk only slightly, but there is a risk that the impact of top selections will quickly fade.

Figure 3. Active risk diversification

Hedge Fund Image 3

Institutional investors interested in hedge funds face a conundrum: They can succumb to their diversification instinct and downplay the mistakes of the asset class. Or they can pick a few managers who could make a difference. Or should they avoid hedge funds altogether?

Hedge fund investments have long contributed not only to reducing alpha for most institutional investors, but in many cases to driving alpha negative, and have taken away the equity exposure desired by long-term investors. There is no strategic merit to a diversified hedge fund allocation. However, if an institution has access to a few really good hedge funds and can resist the temptation to over-diversify its hedge fund exposure, a small allocation may be justified.

understand

appreciate Antti Irmanen Thank you for your helpful comments.


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