How Regulators Killed Hedge Funds

Hedge funds generated much larger returns than stocks and bonds for years — but everything changed after the financial crisis.

Illustration by II

Illustration by II

Hedge funds have fallen short on their promises — and new research expects that performance will continue to trail the broader market for at least the next five years.

Aggregate hedge fund performance has declined over the past decade, according to a research paper that will be published in the CFA Institute’s Financial Analysts Journal.

Between 1997 and 2007, an equally weighted hedge fund index had a cumulative return of 225 percent, beating an equally weighted stock and bond portfolio, which delivered 125 percent. However, the hedge fund portfolio returned 25 percent between 2008 and 2016, compared to a 70 percent return for the stock and bond portfolio. An investor who only held stocks and bonds during the latter period beat hedge funds even with the drawdowns of the financial crisis, according to the paper, called “Hedge Fund Performance: End of an Era?”

In addition, the paper concluded that the percentage of funds delivering what the academic world calls “positive and significant alpha” declined from about 20 percent to 10 percent over the entire sample, while the percentage of funds generating “negative and significant alpha” went from 5 percent to, at times, 20 percent.

The research was constructed to answer a number of questions, including whether aggregate hedge fund performance has generally declined over time, the likely causes of any decline, and what the findings mean for future hedge fund investments. In contrast to other studies that use an un-investable hedge fund index to represent an institutional investor’s hedge fund allocation, the researchers tested whether prediction models can select individual funds that will outperform.

“We wanted to answer the question, ‘Would the investor be better off with or without an allocation to hedge funds?’” Nicolas Bollen, Frank K. Houston Professor of Finance at Vanderbilt’s Owen Graduate School of Management and a co-author of the paper, told Institutional Investor.

According to Bollen, using a hedge fund index as a stand-in for a hedge fund allocation “overstates their benefit in a way, as it allows for an unrealistic degree of diversification. No investor can invest in all hedge funds at the same time.”

The authors of the research, who included Juha Joenvaara and Mikko Kauppila along with Bollen, instead examined portfolios with 15 funds selected from a given quintile, based on a JPMorgan Chase & Co. survey of institutional investors, which found that on average these investors use between 15 and 20 hedge funds in their portfolios.

“We found that there is really a pronounced shift over time. If you look at roughly the first half of the sample, the hedge fund allocation would have substantially reduced the investor’s risk without affecting the average return. So on a risk-adjusted basis the investor is better off. If you look at something like the Sharpe ratio, it was higher with the allocation to hedge funds, primarily through their diversification benefit,” Bollen said. “But in the most recent period, 2008 to 2016, you get the diversification benefit but at the cost of lower returns. The investor is not better off. They have to pay to get the diversification benefit.”

Bollen and his co-authors primarily attribute the underperformance of hedge funds during the most recent period to two reasons. One is the impact of the sweeping regulatory reforms that came after the financial crisis. The other is the distortion and massive liquidity in financial markets that has resulted from central bank interventions.

“It’s hard to beat passive benchmarks if they are inflated. But there’s a lot more to it than that,” said Bollen.

For one, there’s now massive swings between risk-on and risk-off trading. “You have a flood of capital going into risky assets all at once, and then back again,” Bollen said. “That makes some trading strategies simply not work. Think of a long-short strategy where the manager is long the illiquid asset and short the liquid asset, looking to gain a premium on that. When you have a tide of money in and out, those assets move together or even diverge further as opposed to converging. So it blows up some strategies.”

Regulations May Have Stopped Unwanted Activity — and Alpha

Bollen said the increase in regulation has had some possible indirect effects on hedge fund performance. Funds over a certain size, for example, now have to disclose a lot of information directly to the Securities and Exchange Commission. The disclosure might affect the types of trading that managers do in way that limits their performance.

“It has been shown in prior research that suspicious patterns in returns shrink following regulatory reform — whether or not it is related to the degree of performance decline we document, I’m not sure,” Bollen said. “For example, we know that a substantial amount of trading falls into a gray area of insider trading. When managers hire people in an expert network — say, scientists expert in semi-conductors — they might have inside information. That is certainly alpha. If managers know they are being looked at more carefully that could have a chilling effect on that activity. There’s no evidence to support that, it’s just conjecture.”

Bollen and his co-authors don’t expect central bank policies or regulations to change anytime soon. As a result, all but the most conservative investors may be in for more disappointment.

“Hedge funds in aggregate may not be able to achieve the same level of success going forward that fueled their rise in the mid 1990s to the mid 2000s,” they wrote in the paper. “However, since we find that hedge funds constitute a reliable diversifying vehicle throughout our sample, more risk averse investors can continue to justify a modest allocation to alternatives like hedge funds for their diversification benefit.”