Return of the living dead, hedge fund edition

Return of the living dead, hedge fund edition

Dan McCrum

| Oct 03 10:51 | 10 comments | Share

We interrupt this blog to announce a zombie apocalypse has occurred. Please remain calm and do not adjust your allocations, many hedge funds remain open and fee structures are intact.


There are a lot of smart hedge fund managers out there, as well as a lot that are mediocre, lucky, or winging it. But it turns out they are outnumbered by the ranks of the discontinued, the dead, and the disappeared by almost two to one. Those numbers come to us via the Imperial College Centre for Hedge Funds Research, specifically a paper from last year revisiting “stylised facts” about hedge funds. It came to our attention after we wrote about a difficult comparison with the US stock market that many hedge funds will face in the new year. The UK’s Alternative Investment Management Association responded to our post citing the industry’s 20 year track record: Figures from Imperial College’s Centre for Hedge Research show the industry has generated over 4 per cent per annum of “alpha” or performance above the market, after fees. Very impressive, if you think there is such a thing as a 20 year track record for hedge funds that is relevant to the $2trn industry as it stands today. We do not, for a variety of reasons starting with the zombie hordes above. The academics at Imperial College put together data from the five major hedge fund databases, in order to avoid biases in individual data sets and to account for the fact that 70 per cent of hedge funds only report to one data provider. We document that the number of hedge funds ranges across data vendors from 6,772 for Morningstar to 9,719 for BarclayHedge. EurekaHedge is the largest data vendor in terms of 4,452 active hedge funds. Importantly, the proportion of alive and defunct funds varies significantly across databases. BarclayHedge, HFR and TASS (EurekaHedge and Morningstar) contain relatively more (fewer) defunct funds than alive funds.What they find is that, excluding hedge fund which survive for less than a year and so never really get going, on average a hedge fund reports its performance to a database for 62 months, a shade over five years.

So the life of a typical hedge fund is fleeting, which fits with the idea of violent competition between the smartest people in finance. A true investment edge erodes away as others notice, money piles in and it is competed away. Or market conditions simply change.

Some funds blow up. Some lose key people or see their founders retire rich. Others don’t quite make it to a size where they are profitable, or performance just trails off and assets are pulled.

What that turnover means, however, is that it is incredibly difficult to pick a portfolio of hedge funds that will consistently perform at least as well as the average over a sustained period . Aside from weeding out fraudsters and the foolish in advance, funds must be monitored all the time to watch for signs of death or disaster, and replaced when they do wind up.

Here lies the central problem with building a portfolio of hedge funds in the institutional sense, as opposed to an individual handing a chunk of money to a one or two highly trusted expert money managers to look after.

There is an inherent economic return to stocks and bonds that forms the basis of the capital allocation models underpinning modern investment theory. So an investor of any size can go to Vanguard (or its peers) and have them cheaply deliver investment profits over time.

Put 60 per cent of your cash into the S&P 500, and 40 per cent into the US bond market, then occasionally re-balance back to that ratio to automatically sell high (say when stocks have gone up more than bonds) and buy low .

Owning Vanguard’s S&P 500 tracker and its total bond fund since 1990, rebalancing every new year, an investor would have made 8.3 per cent a year, after fees. The annualized standard deviation, using monthly returns, was 9.1 per cent.

The equal weighted HFRI, by comparison, was a better bet in theory. The annual net return was 10.9 per cent, after fees, with a volatility of just 7 per cent. (All things being equal, you should prefer to match the index fund returns with lower volatility).

We would love to hear about an investor who matched or beat the HFRI over more than a decade with their hedge fund investments, because a further complication comes from the paper, which finds that small is beautiful when it comes to investment returns (our emphasis).

The main results obtained using the aggregate database show that there is economically and statistically significant performance persistence at annual horizon for equalweight portfolios. However, for value-weight portfolios, we document significant performance persistence only at monthly horizons, which implies that performance persistence vanishes rather quickly as the holding period increases. This suggests that performance persistence may be driven by small funds.

And by small, they mean really small: sub $10m, on average. Large is $50m plus.

That may also help to explain why performance for the hedge fund industry was better when it as a whole was smaller. In 2000 hedge funds managed less than $500bn, and it was not until 2005 that assets passed the $1trn mark.

So you just need to spot tiny, nimble funds and then bail out of them as soon as they start to become successful and attract assets. Easy.

Oh, you’re a slow-moving pension fund with hundreds of millions of dollars to invest. Well, the paper does hold out some hope if investors can just chose the top performing funds without persistent good performance as a guide.

the top decile alphas are still economically and statistically significant even for large funds at annual horizon.

(We would filter for hedge funds with trees or geographical features in their name, and select by firmness of handshake).

However investors in hedge funds have not been good at this at all. One of our favourite papers on hedge funds, by Ilia Dichev and GwenYu, looked at the actual returns earned by investors, rather than those reported to databases by the hedge funds themselves.

we show that the hedge fund portfolio buy-and-hold return over 1980–2008 is 12.6% but the corresponding dollar-weighted return is only 6%, reliably lower than the S&P 10.9% return over the same period, and barely above the 5.6% risk-free rate.

Perhaps Brad Pitt is available to help.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (, the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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