The Value Hedge Funds Produce

Date: Wednesday, April 25, 2012
Author: Bill McIntosh, The Hedgefund Journal

A timely study from Imperial College’s Centre for Hedge Fund Research shows conclusively that hedge fund management strategies produce value. This is the case not only for investors using hedge funds, but for markets and, indeed, countries.

The report, presented by KPMG and AIMA, provides a broad corrective to the poisoned political environment alternative investment firms confront, particularly in Europe. It also serves as a reminder to much of the anecdotal reporting by the mass media that tends to focus on anomalous events in the alternative investment sector.

The key point of the study, entitled ‘The value of the hedge fund industry to investors, markets and the broader economy’ is that hedge funds improve risk adjusted returns. Compared with the 60:40 portfolio split between equities and bonds traditionally employed by pension funds, adding a hedge fund component will provide better performance with less volatility than any basket of stocks, bonds and commodities.

The data, supplied by HFR and covering 1994-2011, show that hedge funds do provide higher returns (9.07% annually after fees compared to 7.18% for stocks, 6.25% for bonds and 7.29% for commodities). What’s more, hedge funds achieved these returns with much less volatility and Value-at-Risk than stocks and commodities, approaching bonds in both areas. The research also shows that hedge funds were significant generators of alpha, creating an average of 4.19% per year over the 18 year period.

For institutional investors, diversification is the one free lunch available. Quite clearly, the performance of hedge funds means that they should be an important component of a diversification strategy. To a large degree, the hedge fund strategy that an investor chooses is irrelevant. Among five strategies, the annualised mean return occupies a relatively narrow band of between 8.25% (relative value) and 10.58% (equity hedge). Only market neutral with an annualised mean return of 5.73% (and very low volatility) and short bias with a 1.04% return (and very high volatility) sit outside the band.

The study also uproots a couple of other fallacies.

One of these concerns the share of performance which accrues to hedge fund managers versus the share that goes to investors. Contrary to some assumptions, investors got almost three quarters (72%) of the performance gains that were generated, leaving managers with the remainder (combining performance and management fees).

Imperial College also conducted a broad review of the literature on how hedge funds impact markets. It shows that hedge funds are impacted by systemic risk in markets, but don’t have an impact on systemic risk. The study also found that short selling bans on financial stocks increased price volatility (buyers had no way to offset risk), while price discovery was also weakened.

Several unalloyed positives emerge from the findings. Most important, hedge funds are one of the few places where stretched pension funds can get outsized returns. Moreover, on the economic and political level, hedge funds have generated tens of thousands of jobs and substantial tax revenue.

These benefits need to be kept in mind. It is in the interest of not only investors, but governments and regulators to do so during a time when the financial system is being remodelled.