Hedge Fund Performance Dominates Over Last 5 Years

Summary

• Relative performance of the hedge fund industry has dominated a majority of asset classes over the past 5 years, marking one of the strongest stretches in the history of the industry.
• The HFRI Fund Weighted Composite Index has outperformed most liquid assets with the exception of the S&P 500.
• The performance has been concentrated in a small number of stocks, and most large-cap US active equity investors have significantly underperformed the broader index.

Relative performance of the hedge fund industry has dominated a majority of asset classes over the past 5 years, marking one of the strongest stretches in the history of the industry.

Seen below, the HFRI Fund Weighted Composite Index has outperformed most liquid assets with the exception of the S&P 500. However, this performance has been concentrated in a small number of stocks and most large-cap US active equity investors have significantly underperformed the broader index.

Most sophisticated public pension funds experienced enhanced returns

Unlike top endowment funds, which have had significant allocations to hedge funds for decades, most public pension funds did not begin developing direct hedge fund allocations until well after the 2008 financial crisis.

Since then, many of the most sophisticated pension funds have established diversified, uncorrelated asset allocations, primarily funded by reallocating away from fixed income with a goal to enhance overall returns and reduce volatility.

In the past five years, hedge fund indices have not only outperformed fixed income, but have also avoided the extreme declines seen in long-duration fixed income investments.

Hedge fund performance is much higher for institutional investors than reported by indices

Hedge fund indices often under-report the performance of the industry because calculations include "full fee" share class performance. This does not take into consideration the vast majority of managers who give fee discounts to large investors.

For example, large institutional investors committing over $100 million to a manager can often receive discounted fees typically ranging from 50 to 100 basis points less than standard fees, which increase their net return.

Hedge fund fee structures have evolved over the years in order to attract and retain large institutional investors. Most managers have adopted one of the 2 structures below:

• Schedules that tier fees based on the size of an allocation: This model has been standard practice in the long-only space for decades. This permits managers to avoid individual negotiations by reducing fees for larger allocations through a sliding scale fee schedule included in their PPM (Private Placement Memorandum) available to all investors.

• Tailored fees to address specific issues of prospective institutional investors: This involves a give and take across multiple factors including not only management and performance fees, but also performance hurdles, performance crystallization time frames, longer lock-ups, and guaranteed capacity agreements.

Hedge fund performance can also be enhanced through active management

There is significant potential for increased performance for investors who can identify strategies that will outperform or select top-tier managers within a specific strategy.

Hedge Fund Indices encompass a wide range of strategies, and the Hedge Fund Research (HFR) database tracks over 5,000 funds.

Agecroft Partners estimates that approximately 85% to 90% of these funds may not be of high quality. By focusing on the top 10% to 15% of the highest-quality funds, which are not always the largest managers, investors can aim for significantly higher returns than those provided by the broader index.

A significant challenge in the hedge fund industry arises from the tendency of less sophisticated investors predominantly investing in the most prominent fund managers.

This preference is often driven by the allure of established brand names, endorsements from other institutional investors, and the fame of the portfolio manager.

Regrettably, this excessive concentration of capital within the largest funds leads to their assets growing beyond the point where optimal returns can be achieved for their investors.

As these funds expand, their ability to enhance performance through security selection diminishes, resulting in declining returns. For example, there are 2 ways to calculate the performance of the HFRI index:

• Fund (Equally)-weighted: For an equally weighted index, the performance of each fund included carries the same importance regardless of fund size. Performance is calculated based on the average performance of all funds included in the index. This structure best reflects the performance of the average hedge fund globally.

• Asset-weighted: For an asset-weighted index, weight in the index is distributed based on the asset size of a hedge fund, where a $10 billion hedge fund will have a hundred times the weighting of a $100 million fund. This leads to the index performance being dominated by the largest funds and more closely reflects the performance of all assets invested in hedge funds. Since small and mid-sized hedge funds have outperformed large hedge funds over time, this structure tends to underestimate the performance of the average hedge fund.

Over the past 5 years, smaller funds have significantly outperformed larger funds as demonstrated by the HFRI Fund weighted composite that was up 4.9% vs. the HFRI dollar weighted composite that was up only 3.8%. Small and mid-sized managers have a distinct advantage in generating returns through security selection, especially in less efficient markets.

Outlook moving forward

Hedge fund absolute returns should improve going forward for 2 reasons:

• Higher risk-free rate: With the risk-free rate rising to approximately 5%, from close to 0% 2 years ago, many hedge funds strategies will benefit from the increased yield. This includes fixed income-oriented strategies and strategies that typically have large cash positions (i.e. Commodity Trading Advisors (CTAs), reinsurance, long short equity strategies which will benefit from higher rebates on their short positions).
• Greater alpha opportunities due to higher volatility: The capital markets have experienced increased volatility this decade as compared to the previous decade. We expect this to continue as the world evolves from an easy-money environment. Higher volatility creates an opportune market for managers to outperform passive benchmarks. Larger price movements help skilled hedge fund managers add value through security selection and as valuations reach price targets more quickly, managers are then able to capture gains and reinvest in other opportunities more frequently.

Original Source: Author

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.