Just how risky are hedge funds?

Craig nice article and wish you guys continued success. Australia, in comparison to the rest of the world has historically shown better active management performance. For many active managers it is not surprising to outperform a cap weighted benchmark. For example, small cap tilts, momentum filters, leverage et al. can add to an 'alpha' but they do introduce other risks beyond price volatility (as you highlight).
While there is no argument on which performance is preferential in the comparison you have shown, the question is are there better benchmarks to compare hedge fund performance against?

For example, in the US S&P 500 risk controlled benchmarks that utilise simple - transparent rules that manage net exposure dynamically provide similar or superior risk adjusted returns than hedge fund performance whilst avoiding the opaqueness and high fee environment of hedge funds.
Locally, managers have adopted similar rules based approaches to manage exposure directly without the historically high fee structures.

Thanks M Armitage,

Absolutely, there are more appropriate benchmarks and I wouldn't suggest that a long only equity index should be used to directly compare the performance of hedge funds against - I am only using it in this example to refute the notion that hedge funds are more risky than equities.

For me the problem is which hedge (or managed) fund to choose? According to S+P Dow Jones 76% of funds failed to beat the ASX 200.

A while ago Canstar surveyed fund performance and found that over time their performance averaged out.

S+P "There is no consistent trend in the yearly active versus index figures, but we have consistently observed that the majority of Australian active funds in most categories fail to beat the comparable benchmark indices over three- and five- year horizons."

No wonder investors are chasing bricks and mortar.

Roger, I don't think you are alone in that regard - it isn't easy but it is possible. There are a small number of managers who have shown an ability to outperform over time.

Although it may seem convenient, the use of 2007 is really not cherry picking - it is the launch date of the fund used in the example. If I was to use the performance of another well managed fund of hedge funds with a longer track record I have no doubt that the difference would be even more stark in favour of the hedge fund portfolio on both an absolute and relative basis.

True, 2008 was particularly difficult for equities but it was also the most difficult period for hedge funds on record. In fact, this particular fund launched straight into a very difficult period for hedge funds in late 2007 that was dubbed the 2007 quant meltdown (or something along those lines).

On the fee front, those returns (3x equities with 1/3 of the volatility) are quoted after all fees (two layers of them - this is a fund of hedge funds) and the product still outperformed equities on an absolute and relative basis. It also produced those returns with an equity beta of less than 0.2 so there is a lot of alpha there if you measure it by conventional means.

As an investor in hedge funds, would I like to pay lower fees - for sure. But what I think is more important is trying to judge the relationship between the fees paid and the performance outcome to make sure it is balanced appropriately. Hedge funds in aggregate may charge more than long only or index managers but the good hedge fund managers more than earn that back for their clients by participating in the good times while also protecting capital against market declines and this is a key component of building wealth over time.

There are hedge funds with reasonable fees out there that I know. Not everyone charges high fees.

It is like everything. You need to choose the better options and these are quite often not the big brand names that everyone knows. Although some hedge fund investors just aren't open minded when it comes to considering new and better managers - that is their clients' loss and ultimately reflected in their performance. More open minded hedge fund investors could and should have done massively better than Australian equities in recent times.

Using 2007 as the starting point for the returns period is cherry picking. On the flip side, hedge fund haters cite the massive underperformance against the S&P 500 since 2009. Using either of those statistics to run an argument is biased.

The common saying that hedge funds are a compensation scheme masquerading as an asset class sums up the major problem. They may be less volatile, but the alpha versus equities (if any) is often more than consumed by the 2 and 20 fees. If they were run at a reasonable fee level, like 0.2 and 20 with a fair benchmark then there would be a lot more take up.

The biggest risk most investors currently face and usually face is their exposure to market risk and the risk of a large sell-off in broader markets causing a large and potentially permanent loss of investment capital. I would argue this risk is almost as big as ever currently because we have ridiculous monetary policy settings by central banks worldwide, creating significant mis-allocation of capital and valuation distortions. Low interest rates are not and will not fix the economic challenges we face, and very little has been done since the GFC to address the real underlying issues.

Thoughtful investors hence typically need to reduce and diversify their market risk. A critical thing investors can do to reduce their market risk is to invest more actively and with more active managers. Investing actively in order to reduce market risk and make a return - that is best done in a good hedge fund structure ("hedges" the market risk!).

Investors can reduce their risk of the odd bad apple by doing their due diligence or paying someone to do it for them. A fund closing and returning its money to you because it can't make the business work is not a great failure for the investor, unless it loses you money.

I'd also suggest avoiding those with long term track records of mediocre performance. Why on earth would you invest with someone who has demonstrated over a long period of time that they can't add much value? (a proven lack of skill) - that is one of the biggest mistakes investors make.

But the biggest mistake currently is thinking that you're safe by investing in the broader market. You are anything but.

Most investors see hedge funds as “risky” because they are largely opaque obscure processes that by definition don’t fully reveal what they are doing. They could be the next Bernie Madoff. Something like 10% or more of all hedge funds fail and close down every year, so that makes them “risky”, notwithstanding how individual funds might perform.

Thanks for your comments Gary M

One of the points I raise in the article is that I believe the overwhelmingly negative public perception of hedge funds is largely due to a small number of failures or frauds that people outside the hedge fund industry believe is actually representative of the industry when in fact it is not. Madoff is a case in point and is a great example of a fund which was avoided by the more astute investors.

Disclosure levels vary across the industry and the investor is free to decide if what they receive is sufficient for their needs. If we aren't comfortable with the information we get we don’t invest but to suggest that all hedge funds are opaque and obscure is simply not accurate. Disclosure has in general increased across the industry and as an active hedge fund investor I am very comfortable with the level of disclosure we receive from both existing and potential managers. The level of regulation on hedge funds has increased exponentially over the years; a publicly visible example of which would include any institutional investment manager that manages over $100m of qualifying assets has to report their holdings to the US SEC on a quarterly basis – and this information is made public.

The number of hedge fund closures you cite is accurate but you shouldn't confuse closures with funds that lose money, and more specifically large amounts of money for their investors – the vast majority of closures are because the fund does not raise sufficient assets to reach scale so the money is returned to investors – incidentally, this often occurs when the fund has actually generated profits.