By Nathaniel Luce
Twenty years ago, hedge funds in aggregate generated substantially larger returns than portfolios of stocks and bonds. That trend flipped at the onset of the financial crisis, and the chorus of hedge fund naysayers has grown louder ever since. A new study confirms that there is significant cause for pessimism toward the high-profile investment strategy.
In the paper “Hedge Fund Performance: End of an Era?”, to be published by the CFA Institute in the Financial Analysts Journal, researchers found that hedge funds typically fell short of the return of an equally weighted portfolio consisting of the S&P 500 and a total bond market index fund over the period 2008-2016, even in scenarios where less-successful funds were swapped out for larger earners on an annual basis.
“Hedge funds have underperformed generally, but even selecting a subset of funds using performance prediction models wouldn’t have helped you,” said Nick Bollen, Frank K. Houston Professor of Finance at Vanderbilt’s Owen Graduate School of Management and a co-author of the paper. Professor Bollen and his co-authors found that an allocation to hedge funds would have increased the risk-adjusted performance of a stock and bond portfolio over the period 1997-2007, but would have resulted in significantly lower returns thereafter.
The co-authors – Professor Bollen, Professor Juha Joenväärä from the Aalto University School of Business, and PhD candidate Mikko Kauppila from University of Oulu – analyzed a variety of possible explanations for hedge fund underperformance. They found two supported with evidence from their study – heightened regulatory oversight and central bank intervention.
Regulatory impact from passage of 2010’s Dodd-Frank Act takes several forms. The larger cost of compliance with increased regulation is one factor. In addition, past research in the area of financial regulation has shown that various measures of misreporting decline in the wake of heightened regulation, which can result in lower observed performance.
Additionally, central banks around the world have stepped up intervention measures in the wake of the financial crisis and continue to do so to this day, with more frequent and larger stimulus actions. This period of heightened intervention may have depressed volatility and increased correlations in many asset markets, which makes some trading strategies employed by hedge fund managers more difficult to execute.
The study’s findings suggest that hedge fund performance will continue to trail the broader market in the years following the period of analysis because of the potential underlying causes. And, based on the performance of many HFR hedge fund indexes, hedge funds have continued to underperform on average from 2017-2020. “Distortions created by central banks and the impact of regulation are long-lasting, so it’s reasonable to expect that hedge fund performance will continue to lag relative to their prior success from the mid-90s through the mid-2000s,” said Bollen.