Hedge funds success may not be all it seems
tinyurl.com
By Steve Hays
Reuters
Fri Feb 11, 2005
GENEVA - Hedge fund indexes strongly overstate the industry's investment success and far too much money is being drawn into the funds as a result, with possibly dire consequences in the future, a leading U.S. academic said.
"Between 1998 and 2004 there has been enormous growth in hedge fund assets to about $1 trillion and since they are typically leveraged their buying power is much greater. Hedge funds often account for the lion's share of trading on the New York Stock Exchange," Burton Malkiel, professor of economics at Princeton University said.
He was presenting new hedge fund industry research at the Institutional Fund Management 2005 conference in Geneva this week organised by ICBI.
"Do I have a degree of scepticism about hyped returns? Am I worried too much money is chasing future returns? Yes. Let the buyer beware," Malkiel said.
On the face of it, hedge funds appear to have offered exceptional performance as stock markets boomed in the 1990s, then bust in the 2000-2002 post dot-com bear period, before flattening out and offering single digit investment returns.
Between 1988 and 2003 the Van Global Hedge Fund Index showed compound returns of 15.9 percent, compared with 5.9 percent for the MSCI world equities index and 2.3 percent for the S&P 500 stock index.
Much of the hedge funds' success was attributed to their ability to sell equities short, and so preserve capital during the downturn in stock markets, while traditional long-only funds haemorrhaged losses.
But Malkiel said the freewheeling nature of the hedge fund business, with their freedom to choose whether to report performance results and which numbers to publish, compared with the obligatory quarterly reporting of U.S. mutual funds, injected a strong positive bias into industry databases.
BACKFILL BIAS
A major problem is "backfilling," where a hedge fund manager might for example submit numbers for two months of strong performance to a database and omit the first month of mediocre returns.
Malkiel analysed hedge fund returns for backfill bias between 1994 and 2003 and found that with backfill these averaged 14.29 percent, but without backfill 8.45 percent - a 584 basis points difference in performance.
Another problem with hedge fund data is "survivorship bias" as they have a much lower survival rate before being closed down than mutual funds, meaning indexes tend to reflect the results of successful funds rather than poor-performing dead funds.
Of 604 funds in the TASS hedge fund database in 1996, some 480 had "died" by 2003.
"There was a 740 basis points difference between live funds and dead funds. If you want to get a feeling of how hedge funds have done, you also need to look at dead funds. From the standpoint of the performance of the industry, you have to look at the whole industry," Malkiel said.
He added that there was also a wide difference in the performance of general hedge fund indexes produced by companies such as CSFB/Tremont and HFR and their investable indices of more liquid funds - which is much lower.
Malkiel said there was a huge gap between the performance of the top hedge funds and the bottom level of the hierarchy, which is much wider than for traditional mutual funds.
"The manager selection risk is high. The performance of the best funds is outstanding."
This would tend to support the hedge fund industry's argument that performance is all about trading skill and justifies the high fees and contacts need for entry to the "exclusive club" of best funds. Investment endowments of U.S. Ivy-league universities frequently get in by using the contacts of their alumni, Malkiel said.
But when he looked at the probability of "hedge fund winners last year also being hedge fund winner this year," repeat winners only happened on average about 50 percent of the time.
Short-biased equity funds that performed very well in the bear market of 2002 did very poorly in the positive stock markets of 2003, he said. The most consistent top quartile winning strategy appeared to be equity market neutral, he added.
Where hedge funds do justify their position in an investment portfolio is in diversifying risk, as they have a low correlation to major equities and bond markets, Malkiel said.
"Hedge funds say they are wonderful diversifiers and have a beta (market correlation) of 0.23 which is very, very low. But they often input stale prices and when you input real prices the beta goes up to 0.39. Yes they are good diversifiers, but not as good as advertised," he said.
"I can't believe the markets are sufficiently inefficient to justify the hedge fund fees involved - this is a wonderful business. My message is, I think it's an area where you have to be particularly cautious, particularly when people are rushing like lemmings to get into it." |
