This is a summary of “Hedge Fund Performance: End of an Era?,” by Nicolas P.B. Bollen, Juha Joenväärä, and Mikko Kauppila, published in the Third Quarter 2021 issue of the Financial Analysts Journal.
Hedge fund performance has weakened markedly since the financial crisis. No prediction model to select hedge funds could have overcome this trend, and the drivers of underperformance are still in place today.
What’s the Investment Issue?
Many investors are disappointed by the performance of their hedge fund investments relative to passive indexes since the 2008 financial crisis.
The authors of this article examine whether hedge fund performance really declined in the years following the financial crisis. They investigate which (if any) models could predict groups of hedge funds that consistently outperform their peers. They go on to suggest the most likely explanations for the decline in hedge fund performance and the implications for allocations to hedge funds going forward.
How Do the Authors Tackle the Issue?
The authors measure aggregate hedge fund performance in the decade before the financial crisis (1997–2007) and the years after the crisis (2008–2016). They use consolidated data from six commercial databases to compare returns from the two periods.
They test whether established models can successfully unearth subsets of hedge funds that consistently outperform. They do this by simulating the random selection of 15 funds from the top quintile as ranked by the models and repeating this simulation process 1,000 times.
The authors then compare the performance of a standard stock and bond portfolio with no hedge fund exposure with that of multi-asset-class portfolios that include a 20% allocation to hedge funds selected by these models.
Lastly, they consider why aggregate hedge fund performance might have declined in the years following the financial crisis.
What Are the Findings?
Hedge fund performance has weakened markedly over the past decade. An equally weighted hedge fund index returned a cumulative 225% from 1997 to 2007 but just 25% over the 2008–16 period. The percentage of hedge funds with significant alpha dropped from approximately 20% before the financial crisis to just 10% after it, while the proportion with significantly negative alpha rose from 5% precrisis to approximately 20% postcrisis.
Two of the models led to a substantial increase in the multi-asset-class portfolio’s Sharpe ratio compared with that of the stock and bond portfolio over the full period in question (1997–2016). These models are the alpha from the Fung and Hsieh (“Hedge Fund Benchmarks: A Risk-Based Approach,” Financial Analysts Journal, 2004) seven-factor benchmark, which has become the standard for estimating risk exposures and managerial performance, and the macro timing measure of Bali, Brown, and Caglayan (“Macroeconomic Risk and Hedge Fund Returns,” Journal of Financial Economics, 2014). Both models improved the Sharpe ratio by substantially reducing the volatility of the multi-asset-class portfolio. However, the research shows that after the crisis (from 2008 to 2016), the hedge fund allocation reduces volatility but also lowers returns, meaning the Sharpe ratio sees no improvement.
The authors argue that given that the breakpoint for hedge fund performance seems to be 2008, the explanation for the deteriorating returns lies with the onset of the financial crisis. In particular, central bank interventions created increasing correlations of risk assets and reducing volatility, which led to the failure of many previously robust hedge fund strategies. In addition, increased regulation, particularly via the Dodd–Frank reforms of Wall Street practices, created additional compliance costs and curtailed some profitable hedge fund trades.
What Are the Implications for Investors and Investment Managers?
None of the established models could be applied to overcome the aggregate deterioration in hedge fund performance in the post–financial crisis era. That hedge funds in aggregate might not achieve the same level of success going forward that they enjoyed from the mid-1990s to the mid-2000s seems probable. Given that the post–financial crisis era of heightened regulatory scrutiny and central bank market intervention could persist, the authors warn that investors might need to “recalibrate” their expectations downward for future hedge fund performance.
Conservative investors can nevertheless justify making a modest allocation to hedge funds for their diversification benefits.