A New Era For Hedge Funds? by Lyxor
Executive summary
We evaluate the drivers of hedge fund returns and conclude that the normalization of US monetary policy and US equities’ loss of momentum will lead to HF outperformance versus traditional asset classes. We expect annual excess returns in the 5-6% range.
Hedge funds have underperformed traditional asset classes over recent years. Despite its outstanding track record over recent decades, the industry has come under mounting pressure. Inflows remain robust, but hedge funds have significantly lowered both management and performance fees to adapt to the new environment.
We evaluate the causes of the underperformance and find that the fall in bond yields in the wake of the Fed’s QE programme has negatively impacted hedge funds. Additionally, the equity beta has fallen while stocks rallied and alpha generation has shrunk as a result of the low volatility / low dispersion environment. However, alpha generation has started to rise since mid-2014 and the environment is now improving, with valuations stretched across the board, the economic cycle maturing and the Fed beginning to normalize monetary policy.
Going forward and based on conservative assumptions, we estimate that hedge funds could deliver annual excess returns in the 5-6% range with low volatility. We believe that diversifying portfolios with an increased allocation to alternatives is particularly attractive at this point in the cycle. Hedge funds have demonstrated their ability to protect portfolios against wide market fluctuations, a scenario that we cannot exclude as the Fed turns the screw.
Hedge funds have underperformed recently but their long term track record is outstanding
Hedge funds have come under fire recently…
Hedge funds have come under mounting pressure over the past five years in terms of their ability to deliver returns in line with investors’ expectations. The bulk of the criticism has been essentially related to the accusation that hedge funds collect fees that are allegedly no longer in line with the performance they generate. In this report, we discuss the reasons for such criticism and address the question of hedge funds’ expected returns going forward.
To begin with, the chart below shows that hedge funds have in fact underperformed traditional asset classes since February 2009. Since this date, global equities have delivered compound annual returns close to 18% per year (in total return) while hedge funds have generated compound returns below 8%. Similarly, a diversified portfolio composed of equities and bonds (60/40 respectively) has also generated substantially higher returns at 12.7% per year.
From another perspective, the underperformance of hedge funds has also been seen on a risk-adjusted basis. The chart below shows that since February 2009, both our diversified portfolio and a fixed income benchmark have outperformed hedge funds on a risk-adjusted basis. However, hedge funds outperformed global equities on a risk-adjusted basis thanks to their substantially lower volatility.
It is interesting to note that looking beyond the overall hedge fund underperformance, some strategies have stood out as strong performers. The Relative Value and Event Driven strategies have shown the highest Sharpe ratios since 2009, respectively outperforming the fixed income benchmark and a diversified portfolio. On the other side of the spectrum, Equity Hedge and Macro managers have underperformed, in particular the so-called systematic diversified sub-strategy (CTAs). It is therefore important to keep in mind that hedge funds constitute a heterogeneous asset class. Picking the right strategy and the right fund is the key here.
The underperformance of hedge funds has put the industry under pressure. Although hedge funds continue to raise money year after year (with global AuM now reaching USD3 trillion), fees have been trending downward.
The chart below highlights the fact that the “two and twenty” hedge fund fee structure no longer prevails. The current average fee structure for the industry is a 1.5% management fee and 17% performance fee. On average, the smallest hedge funds have the highest fees (1.53% / 18%) while the largest have the lowest fees (1.37% / 16%).
…in spite of an outstanding track record
Four Stylized Facts
Historical data on hedge fund performance dates back to the early 90s. With 25 years of reliable data on hedge funds across different business cycles, we are now able to draw strong conclusions regarding the asset class in both absolute and relative terms. As such, we discuss in this section four principal stylized facts: absolute performance, relative performance, risk-adjusted performance and decorrelation:
– The absolute performance of hedge funds has been outstanding: We calculate that annualized returns of hedge funds after fees since 1990 have been above 10%. We also calculate that hedge funds have been strong generators of “alpha”, creating an average of 4.5% per year between 1990 and 2015.
– The relative performance of hedge funds versus traditional asset classes has also been remarkable over the long term. Hedge funds have delivered returns above those achieved by equities and bonds or a diversified portfolio, as shown by the chart below.
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