Equity benchmarks unsuitable hedge universe measure
Hedge funds should be compared with the most relevant asset class and it may make more sense to examine the success of a particular strategy in relation to bond performance rather than equities
In announcing funds under management as at March 31 of $55 billion, up $900 million on Q4 2013, Manny Roman, chief executive of Man Group, told shareholders last month that the market environment in the first quarter has been particularly challenging for the industry and, while the company is pleased to have recorded a solid quarter of net inflows, it remains cautious in outlook for asset flows for the rest of the year, given recent mixed absolute investment performance.
He will not be alone in sharing such concerns.
Indeed year-to-date, according to the Hennessee Hedge Fund Index, hedge funds are up 0.79% while the S&P 500 is up 1.93%. Further, the HFRI Fund Weighted Composite Index posted a decline of -0.17% for the month of April, the second consecutive decline for the HFRI, bringing index performance year-to-date through April to +0.9%. The declines in March and April mark the first time the HFRI has posted consecutive monthly declines since April and May 2012.
Some investors are starting to turn their backs on hedge funds. Calpers, the mammoth $289 billion California-based pension fund, is reported to be considering cutting the system’s $5.3 billion hedge fund allocation in half, with a board decision due in Q3 on the proposal. The move would represent a symbolic blow to the industry as the institutional investor was an early pioneer taking the plunge into hedge funds, with a programme dating back to the early 1990s.
Yet, despite the naysayers, hedge fund industry assets continue to reach all-time record highs. Investors carried on allocating heavily into hedge funds in March, according to data provider eVestment. While performance accounted for a $6.5 billion decline in March, an $18.3 billion influx of new capital during the month lifted Q1 2014 net flows to $55.1 billion, a level last surpassed in Q2 2007. Total assets under management of $2.931 trillion at the end of Q1 2014 were just shy of the industry’s Q2 2008 peak of $2.938 trillion.
It is, of course, a little disingenuous to hold up the returns from a multi-strategy hedge fund portfolio – comprised of many funds that may have no equity exposure – against the performance of a benchmark such as the S&P 500.
The Alternative Investment Management Association (Aima) has published a helpful new educational guide on how to better understand hedge fund performance. It says looking at hedge fund performance next to that of the S&P 500 can be an “apples and oranges” comparison.
In the first instance, Aima urges investors to look at long-term data as short-term figures, such as monthly comparisons, can be misleading, and points out that hedge funds have outperformed the main standalone asset classes over 10 years to the end of 2013 both in terms of headline returns and on a risk-adjusted basis. The differences between hedge fund indexes should also be noted; during the five years to the end of 2013, the main hedge fund indexes produced notably different results, reflecting variations in constituency and methodology.
But, most importantly, the association stresses that hedge funds are not an asset class and that there is no such thing as the ‘average’ hedge fund. Hedge funds should be scrutinised in parallel with the most relevant asset class; it may make much more sense to be comparing a particular strategy with bond performance rather than equities. Prior to 1990, a large part of the hedge fund industry was US long/short equity so a contrast to the S&P 500 was apt, but that is no longer the case.
The comparison to fixed income also has broader significance for institutional investors. As consultant Agecroft states, since most of the new flows into hedge funds are coming from fixed income and not equity portfolios, many institutional investors in the short term will be happy if their hedge fund portfolio outperforms their fixed income portfolio, validating the decision they made; most institutions are currently using a return assumption of between 4% and 7% for a diversified portfolio of hedge funds, which compares very favourably with core fixed income, where the expected return is only 2.5% to 3%.
As Aima also concludes, institutional investors tend to prefer steadier returns, achieved with less volatility, to higher returns with the cost of greater volatility and, from that perspective, examining performance in relation to benchmarks other than equities may be more appropriate.
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