We are probably the most popular hedge fund tracking website in the World. Hedge funds weren’t a very popular topic among financial journalists when we launched our site 4 years ago. Nowadays we read at least a dozen stories about every week and all of them either contain blatant mistakes or exclude vital facts about hedge funds. We haven’t seen a factually complete article about hedge funds over the last 4 years, so we decided to write one. Here are the 6 things you probably didn’t know about hedge funds:
1. You shouldn’t compare hedge fund returns to the S&P 500 index’s return. These days hedge funds are about 50-60% net long. If the market goes down 36%, an average hedge fund will probably go down about 18-21% because of the decline in the market. That’s what we observed in 2008. If the market goes up 30%, an average hedge fund will probably be up about only 15-18%. It isn’t surprising at all to see hedge funds underperform in a bull market and outperform in a bear market. It isn’t rocket science.
2. There are three components of net hedge fund returns: return that’s a function of beta exposure, abnormal return generated because of fund manager’s skill (this is called alpha), and management and performance fees. We explained the return generated by beta exposure in the previous section. There is no skill involved in generating returns by being 50-60% net long. If you allocate 50-60% of your portfolio to an index fund, you can easily replicate an average hedge funds’ returns pretty accurately. Hedge fund managers used to generate high single digit alpha until 2005. More recently the average alpha generated by an average hedge fund went down below zero (see the figure below as calculated by quant hedge fund manager Cliff Asness). This is an approximation but other methods will probably yield similar results. Asness’ analysis uses “net hedge fund returns”. This means hedge fund managers can’t generate enough alpha to justify their sky high management and performance fees. In other words, if you had allocated 50-60% of your portfolio to an index fund and kept the remaining portion in T-bills, you would have outperformed the average hedge fund investor by a couple of percentage points per year over the last couple of years.