NASHVILLE, TN, USA, October 31, 2002 Hedge funds have been in the news quite a lot recently, and much of the reporting has been negative. Has it presented a balanced view? Let’s examine that question, review hedge fund performance for the industry as a whole and then conclude with a diagnosis of the health of the hedge fund industry, warts and all.
Hedge Fund Performance In 2002
- Through September, the average U.S. hedge fund has lost –3.6%; in the same period, the Average Equity Mutual Fund ("AEMF") and the S&P 500 have lost –25.0% and –28.2% respectively.
- About 50% of all hedge funds have been profitable year-to-date. Juxtaposed against the carnage among equity mutual funds, only 3% of which have been profitable through September, hedge funds look good.
- The top quartile of U.S. hedge funds has provided an average return of 16.4% this year, through September, compared to a loss of –9.2% for the top-performing quartile of equity mutual funds. Again, quite a dichotomy and one that explains why hedge funds increasingly are the investments of choice for many sophisticated investors.
- >p> Hedge Funds In The Current Bear Market
Before we examine the longer-term performance of hedge funds, let’s first check their performance since the beginning of the bear market. Since April 1, 2000, the average U.S. hedge fund actually has been profitable æ with a positive return of 2.6% æ while the AEMF and the S&P 500 have lost –41.3% and –43.8%. These dramatic numbers speak for themselves.
How About The Last 14.75 Years?
In the 14.75 years of Van U.S. Hedge Fund Index data, the average U.S. hedge fund has produced a 17.0% compound annual return versus 8.2% for the AEMF and 11.1% for the S&P 500.
This longer-term outperformance of hedge funds also has been accompanied by less risk, using conventional risk measures. For instance, consider standard deviation, which measures volatility and often is equated to investment "risk." The average U.S. hedge fund has had an annual standard deviation of 9.1%, compared to 15.9% for the AEMF and 15.5% for the S&P 500. Other risk comparisons are equally favorable to hedge funds.
Why Do Hedge Funds Often Get Such Terrible Press?
On average, hedge funds have protected investors’ assets much better than mutual funds or stocks. Why then do many hedge fund stories tend to be negative? Having been engaged in an active dialogue with media representatives for many years, I know them to be fair and objective. I suggest several logical reasons for many negative hedge fund stories: Bad news makes for more dramatic reading than good news. We’re all aware of this truism, which has applied forever to all forms of news, not just hedge funds. So when a hedge fund manager takes a nose dive or, worse still, is accused of wrongdoing, that news understandably makes for more interesting reading.
- Hedge funds and their investors don’t anticipate big declines. If a mutual fund is down 50% or so in this market, it probably won’t make headlines. But a hedge fund drop of 50% is unusual æ and so this often does make the news, particularly if the fund is large.
- The general public has little familiarity with hedge funds. Hedge funds only started their significant growth spurt in the mid-1990s, a trend that has continued. However, with only an estimated $600 billion under management worldwide at this point, they aren’t very visible in the enormous financial markets. Further, they are commonly limited to investors with $1 million net worth and so are not of particular interest to the average investor. So it takes a powerful hedge fund story to be newsworthy.
- Most hedge funds are independently run and less regulated than mutual funds. In relative terms, it is easier for a hedge fund manager to commit malfeasance. Such an event is newsworthy. However, the statistical likelihood of this happening to an investor is extremely low. If this were not so, conservative institutional investors wouldn’t keep increasing their allocations to hedge funds. To protect against rare cases of manager fraud, savvy investors diversify their portfolios with numerous hedge funds to spread the risk. They also perform extensive initial and ongoing due diligence. While few investors perform this due diligence themselves, most either hire others to do it or invest in funds of hedge funds.
If Current Awful Market Conditions Continue, What Of Hedge Funds?
The simple truth is that many hedge funds with weaker returns will close their doors. There is no dishonor in this. It is the price that hedge funds pay for allying their interests with those of their investors. The majority of hedge fund compensation is directly related to performance. (This is in contrast to mutual funds, where the primary driver of income is size, not performance.) When a hedge fund is unprofitable for a year, it typically loses most of its fee income. So, in the current market, with about one-half of hedge funds being unprofitable this year (some of which were unprofitable last year also), most will not receive the fees on which they depend to pay their expenses. Even worse for them, most hedge funds protect investors by agreeing not to charge incentive fees until investors have totally recovered their losses. This means that, for some time after becoming profitable again, a hedge fund will "stay in the penalty box," receiving no performance fees until its new profits have overcome its recent losses.
Already, we are reading about a few hedge funds closing and returning monies to investors. We can expect quite a few more in coming months. Many of these managers have found themselves in the wrong strategies for the times. While most of them actually protected investors against large market losses, because they were unprofitable they didn’t make enough money to stay in business æ due to the compensation arrangements described. Quite a few of them will soon reappear, offering strategies better suited for the current markets.
Let’s Keep The Big Picture In Mind
Remember, for every hedge fund closing that is reported, many more continue to be profitable, both protecting and increasing investors’ assets. Remember too that hedge funds have proven, over time, to be significantly more profitable and less risky than mutual funds or equity investments. Both hedge funds and mutual funds are taking their lumps in a horrible market. But the logic behind hedge funds, which operate with "insurance" such as short positions, is compelling and proven. Hedge funds are here to stay and, in the future, will grow in numbers and continue to capture an ever-increasing percentage of investors’ assets.
Van Hedge Fund Advisors International, Inc. ("VAN") is a global hedge fund advisory firm which constructs hedge fund portfolios for international institutions and wealthy investors. VAN bases its work on its pioneering research on hedge funds begun in the early 1990s and by drawing on a hedge fund database which it believes to be the world’s largest.
[The Company’s hedge fund index information is based on information received (and not audited or independently verified) from the hedge funds in an affiliate’s databases and may not be representative of all hedge funds. Hedge fund returns are net of fees and performance allocations. The timing of the deduction of such fees and performance allocations may affect the reported performance. Different statistics may be based on different numbers of funds. Averages are not dollar-weighted. Past results are not necessarily indicative of future performance. AEMF statistics are derived from Morningstar data.]