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Rekenthaler Report

Will Hedge Funds Ever Recover?

An industry trapped in a time warp.

Following Up
When I began this column in the spring of 2013, one of my early submissions chided hedge funds. Called "Hedge Fund Follies," the article showed that over the previous seven years--a full market cycle, in that it covered the runup to the financial crisis, the collapse, and the subsequent recovery--every category of target-date mutual fund had outgained hedge funds of funds, or HFOFs.

The underlying hedge funds that are owned by HFOFs fared little better. Over that same seven-year period, most hedge fund categories trailed their mutual fund equivalents. For once, man had bitten the dog; the bottom 99% of investors had bested the top 1%.

Five years later, things look worse rather than better. Performance, to put the matter bluntly, has been rotten. That most hedge funds have trailed the stock market during a sustained bull market is unsurprising. They do, after all, hedge. It would therefore be unreasonable to compare them to stock market indexes. However, balanced investment strategies are fair game. If hedge funds can't beat diversified multi-asset funds, what is their purpose?

And no matter how that inquiry is structured, hedge funds have failed.

Unflattering Figures
One approach is to compare hedge fund returns with those of relevant mutual funds. The awkwardly (but precisely named) allocation--50% to 70% equity Morningstar Category is one such group, and the target-date 2035 category another. Over the trailing five years, starting in September 2013, those funds gained 7.3% and 8.6%, respectively. In contrast, the average return for the U.S.-dollar-dominated hedge funds in Morningstar's database was 4.6%. By that measure, hedge fund managers consumed every extra penny they collected in fees, and then some.

(Hedge fund databases being inconsistent, with one database carrying funds that another does not, I checked Morningstar's total against Hedge Fund Research Inc.'s Fund Weighted Composite Index. That index rose by 4.5%--a near match.)

Another test is to create a composite benchmark. Rather than own a hedge fund, an investor could place 40% of assets into a U.S. stock index, 20% into an overseas stock index, 30% into a bond index, and keep the final 10% in cash. Very roughly speaking, that arrangement would mimic the volatility of a typical multistrategy hedge fund while also possessing a broadly diversified portfolio. That benchmark's five-year performance: 8.3%.

There are no reasonable ways to portray the industry's performance positively. Hedge funds followed their disappointing seven-year stretch through 2013 with a half decade that was worse. That makes for a dozen years' worth of collective failure. (Fifteen, really, as they were nothing special from 2003-05.)

Counterarguments
The standard defense for hedge funds is that simple averages, where every fund counts equally, are misleading. Most hedge funds are small, unsuccessful, and ultimately unwanted. They come, and then they go. What matters are the results for the established players--those funds that have proved themselves over time, and which therefore have substantial assets. Their performances indicate how hedge fund performances fare.

Morningstar's figures do indeed show a moderate advantage for the larger hedge funds. (That said, HFRI's numbers do not, as its Asset Weighted Composite Index, which places greater importance on the giant funds, trails its Fund Weighted Composite Index. Hedge fund databases are indeed peculiar beasts.) However, the effect is not strong enough to overcome mutual funds' lead. No matter how it is tortured, the data will not confess to a hedge fund victory.

The next response is that the very best hedge funds--the industry's top 0.1%--don't appear in databases. Those managers are so successful, and are so much in demand, that they need not report their results. The argument is a black hole that cannot be refuted. Perhaps it contains some truth. One wonders, though, how many of these funds will accept new monies, even from their existing shareholders. From the perspective of incoming investors, the superfunds may be more theory than reality.

Little Change
Overall, today's hedge fund business closely resembles that of 2013. Now as then, performance has been insufficient. As a result, the industry has been sharply criticized, and its costs challenged. The once-standard fee structure of 2+20, meaning a 2% annual management fee accompanied by a 20% performance fee (as measured over a prespecified hurdle rate), has drifted down to 1.5+15. Even so, many hedge fund investors have threatened to take their monies elsewhere.

For the most part, though, they have not. At something north of $3 trillion, the industry's assets are their highest in history. True, they have declined slightly as a percentage of overall financial assets because the global stock and bond markets have grown at a faster rate. But as a first approximation of the truth, it is fair to say that hedge funds have not benefited from a shakeout that would ease the investment competition. The same amount of money chases the same number of trades.

Nor have hedge fund sponsors changed their ways. This month, PwC and the Alternative Investment Management Association published "Global Alternatives Distribution Survey 2018: The Right Strategy, at the Right Price." It reads as if retrieved from a time capsule. Just as retail financial advisors believed in 1999, those who run hedge funds believe that the most important factor when selecting investments, by a wide margin, is past performance. Fees place sixth.

Accordingly, although the typical hedge fund costs about 4 times as much as the institutional share class of an actively run fund and at least 20 times more than the major index funds, 78% of hedge fund sponsors stated that they did not plan to cut their fees. Said one of the survey's respondents, the firm "is not interested" in negotiating costs with prospective investors.

Wrapping Up
Five years from now, relative hedge fund results should look better. Odds are, the U.S. blue-chip stocks that drive so many mutual fund performances won't have dominated the global financial markets, as they have recently. That will give hedge funds the chance to demonstrate the merits of hedging. However, with the industry retaining its dated mindset, and trades continuing to be overcrowded, it's difficult to see how the news could be more than mildly positive.

 

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.