Blog - Investing Notes - Hedge Funds Versus Mutual Funds

Date: Thursday, February 15, 2007
Author: CXO Advisory Group, Blog

How are hedge funds like, and not like, mutual funds? How is the hedge fund industry likely to evolve? In his February 2007 paper entitled "Hedge Funds: Past, Present and Future", René Stulz compares the performance and risks of hedge funds to those of mutual funds and examines the likelihood that hedge funds will become more like mutual funds in the future. Based on a review of relevant research, he concludes that:

At the end of 1993 (2005), assets under management of hedge funds were less than 4% (more than 10%) of the assets managed by mutual funds. [See, however, our blog entry of 4/18/05, which suggests some cyclicality in this ratio.]
In aggregate, hedge funds, unlike mutual funds, have a non-negative alpha net of fees. (See the chart below.) Also, in contrast to mutual funds, a significant fraction of hedge funds generate substantial positive alpha. Some evidence indicates that past performance helps identify good hedge funds.
There is no compelling case that hedge funds hurt markets (e.g., by increasing volatility) more than they help (e.g., by moving capital to the right place at the right time).
The performance advantage of hedge funds over mutual funds will narrow as: (1) hedge funds accept constraints required to attract more institutional investors; (2) growing assets under management exhaust the most profitable hedging opportunities; and, (3) regulatory developments limit hedge fund flexibility.
Hedge funds will also face low-cost competition from automated replication of hedge fund performance characteristics (increasingly intelligent software). [See our blog entries of 11/16/06 and 8/30/06.]

The following chart, taken from the paper, shows cumulative returns for 1994 through mid-2006 of 259% for a hedge fund index net of all fees and expenses (10.8% average annual return) versus 241% for the S&P 500 index (10.3% average annual return). The hedge fund index has relatively low volatility, with an annualized standard deviation of 7.8% compared to 14.5% for the S&P 500 index. The Financial Times World Index lags both other indexes.

The paper is a good primer on hedge fund history, organization, operation, performance and risks.

In summary, the small positive alpha of hedge funds in aggregate is likely to move toward the negative alpha of the mutual fund industry in the coming years.

Perhaps hedge funds will have to cut prices as their market moves toward commoditization.