Hedge Funds: Do Half As Well As You Think

Hedge Funds: A Dynamic Industry In Transition

AlphaSimplex Group, LLC

Massachusetts Institute of Technology (MIT) – Sloan School of Management; Massachusetts Institute of Technology (MIT) – Computer Science and Artificial Intelligence Laboratory (CSAIL); National Bureau of Economic Research (NBER)

Mila Getmansky Sherman

University of Massachusetts at Amherst – Eugene M. Isenberg School of Management – Department of Finance

July 28, 2015

Abstract:

The hedge-fund industry has grown rapidly over the past two decades, offering investors unique investment opportunities that often reflect more complex risk exposures than those of traditional investments. In this article we present a selective review of the recent academic literature on hedge funds as well as updated empirical results for this industry. Our review is written from several distinct perspectives: the investor’s, the portfolio manager’s, the regulator’s, and the academic’s. Each of these perspectives offers a different set of insights into the financial system, and the combination provides surprisingly rich implications for the Efficient Markets Hypothesis, investment management, systemic risk, financial regulation, and other aspects of financial theory and practice.

Hedge Funds: A Dynamic Industry In Transition – Introduction

The growth of the hedge-fund industry over the past two decades has been nothing short of miraculous. In 1990, hedge funds managed approximately $39 billion in assets, and despite several industry-wide crises—including the Asian Contagion (1997), Long-Term Capital Management (1998), the bursting of the Tech Bubble (2001–2002), the subprime mortgage crisis (2006–2008), and the ongoing European debt crisis—current estimates put hedge-fund assets at $2.5 trillion. This astonishing rate of growth is not accidental. It reflects a broad and abiding demand for what hedge funds offer: higher risk-adjusted expected returns; greater diversification across assets, markets, and styles; and fewer constraints on portfolio managers who are incentivized to generate unique sources of excess expected returns, i.e., “alpha”.

However, along with these advantages, hedge funds also offer more complex risk exposures that vary according to style and market circumstances— risks such as “tail events”, illiquidity, and valuation uncertainty. Also, because hedge funds enjoy greater latitude in their investment mandate and typically provide little transparency to their investors because of the proprietary nature of their strategies, the possibility of fraud and operational risks is of much greater concern to their investors. If typical hedge-fund investors are considered “hot money”, there may be good reason.

These conflicting characteristics may explain why investors have a love/hate relationship with alternative investments. According to HFR (2013), in 2013Q4 63% of funds of funds experienced fund outflows; however, only 45% of single-fund manager funds did. This is consistent with the general decline in the number of funds of funds, which is attributable to their fees, competition from multi-strategy funds, and their general inability to avoid losses during the recent financial crisis. Relative Value, Equity Hedge, and Event-Driven categories each encompass about 27% of the total hedge fund assets under management. The rest (about 19%) is invested with Global Macro funds. This situation changed dramatically from 1990Q4 when 40% was invested with Global Macro funds, and Event-Driven comprised only 10% of total hedge fund assets. About half (47%) of all hedge funds never reach their fifth anniversary. However, 40% of funds survive for 7 years or longer.

It is now apparent that hedge funds are not simply a fad that will disappear. The industry has matured considerably over the past two decades and now serves critical functions in the global financial system such as liquidity provision, risk transfer, price discovery, credit, and insurance. For all these reasons, a critical survey of the hedge-fund literature seems worthwhile and is undertaken in this article. In addition to providing a review of recent academic studies on hedge funds, we report updated empirical results on their performance and risk characteristics. Given how quickly the industry changes, hedge-fund data from 10 years ago may no longer be representative of today’s reality, especially in the aftermath of the Financial Crisis of 2007–2009.