In the 15 years leading up to 2008, the average hedge fund manager could be expected to deliver excess returns, net of fees. But in the decade following the financial crisis, hedge fund alpha has sharply deteriorated, according to new research out of the University of Virginia’s Darden School of Business.
Risk-adjusted excess returns for hedge funds have averaged negative 0.8 percent over the last ten years, according to the paper by Rodney Sullivan, executive director of Darden’s Richard A. Mayo Center for Asset Management. Sullivan, a former vice president at AQR Capital Management, analyzed the performance and risk exposures of hedge funds operating between 1994 and June 2019.
He found that the last decade of hedge fund performance marked a “strong decline” from the pre-crisis period. In the 15 years leading up to 2008, the average hedge fund manager added 3.4 percent in net risk-adjusted returns, according to Sullivan’s research. The results were similar when he focused only on equity hedge funds.
“Even though reports pointing to poor hedge fund performance often incorrectly compare them to an all-equity benchmark, as we’ve seen, the more accurate market-risk-adjusted performance of hedge fund managers is also clearly not good,” Sullivan wrote. “This has led to some question whether hedge fund alpha, after ten years of low to no alpha, has disappeared altogether.”
[II Deep Dive: Have Institutional Investors Spoiled the Hedge Fund Party?]
In order to understand why risk-adjusted excess returns have declined, Sullivan analyzed hedge fund exposures to stock market risks, bond markets, and other investment factors. Although hedge funds as a group have maintained a “relatively consistent” exposure to market risks, they are now taking much less active risk compared to the pre-crisis period — in other words, hedge fund portfolios hew closer to their passive benchmarks.
Sullivan suggested a number of possible explanations for the “meaningful” reduction in active bets, including the possibility that the growth of the hedge fund industry has diversified away active risk, given the wider array of managers betting on different securities.
“Another possibility for the decline in active risk is that hedge funds identified fewer alpha opportunities in the post-GFC period,” Sullivan added. “That is, there would be little reason for a manager to take active risk absent the concomitant benefit of active return, so both active risk and active return decline.”
Sullivan also speculated that clients of hedge funds sought lower active risk from their active managers in the wake of the financial crisis, a demand which hedge funds have obliged. “This possibility could be due to asset owners being stung by the market turbulence associated with the GFC,” he wrote. “Alternatively, a lower desired active risk could be a result of the demands of changing clientele.”
In addition to taking smaller active bets, Sullivan also found that hedge funds as an industry also decreased their exposure to U.S. bonds and reduced or reversed exposures to factors like momentum and volatility.
“Whether intended or otherwise, hedge funds have clearly altered the way they drive performance including a considerable decline in active risk taken,” he concluded. Still, given that the research was based on hedge funds as a universe, Sullivan noted that there “certainly will be a subset of managers who have delivered alpha over the periods discussed here.”