As is well known, the performance of hedge funds and liquid alternative investments (whose performance track that of hedge funds) has been abysmal, producing negative alpha (i.e., lagging the performance of the S&P 500) while maintaining the high fees and performance share. Despite this performance, funds continue to flow into hedge funds, especially from institutional investors.
Justifying Hedge Fund PerformanceA number of arguments have been put forward to explain (or justify) the poor performance of hedge funds. One such is the argument that the S&P is not a relevant benchmark for evaluating hedge funds because the latter's goal it precisely not to track the S&P. Rather, hedge funds seek to reap absolute returns or provide a superior risk-adjusted return. In more recent times, the justification for hedge funds' performance has been that their true benefit is not to outperform the S&P, but rather to add diversification to investment portfolios, thus reducing their volatility and (possibly) producing increased gains. Finally, hedge funds are rationalized as providing higher Sharpe ratios than the S&P even with lower returns because of their lower volatility.
Hedge Fund Returns are a Function of the Economic EnvironmentA better explanation of hedge fund returns is to view them in the economic and market environment in which they are generated. After all, we have been tracking hedge funds since the early 1990s, yet the economic environment, financial markets and hedge fund strategies have changed radically since that time. Trying to explain hedge fund returns without taking this into account is like trying to explain tides without reference to the moon. A recent research report, "A New Era for Hedge Funds?" offers an extended discussion of this issue, reinforcing the points made above. The report addresses the main problem head on: "...hedge funds have in fact underperformed traditional asset classes since 2009." Source: "A new era for hedge funds?" Lyxor Research, July 2015 But rather than using on the above arguments to explain this discouraging fact, they argue that "the absolute performance of hedge funds has been outstanding" since the early 1990s both on an absolute and risk adjusted basis. The problem is in trying to make an argument for hedge fund performance for periods when they unarguably underperform. Lyxor presents the factors that drive hedge fund performance, and which have driven hedge fund returns downward in recent years: "We evaluated the causes of the underperformance and find that the fall in bond yields in the wake of the Fed's QE program has negatively impacted hedge funds. Additionally, the equity beta has fallen while stocks rallied and alpha generation has shrunk for the very same reason."
Looking back at various business cycles over the past 25 years, Lyxor finds periods that were favorable to hedge funds and others that were not.Source: "A New Era for Hedge Funds?" Lyxor Research, July 2015 However, unlike many analyses that point to the same fluctuations, Lyxor looks for the underlying factors that drive the under- or over- performance. The result is a forecast of hedge fund performance based on factor analysis that is as follows: "Going forward....we estimate that hedge funds could deliver annual excess returns in the 5-6% range with low volatility....Hedge funds have demonstrated their ability to protect portfolios against wide market fluctuations, a scenario that we cannot exclude as the Fed turns the screw."