Hedge funds have attracted a great deal of attention lately, in the popular press and from prospective investors seeking high returns. In India, the hedge fund industry is not quite as well developed as in Europe or the US, but it is growing extremely rapidly, fuelled by fast growth in wealth and the increasing liquidity available in Indian equity and debt markets. Hedge funds are generally considered to be run by financial wizards implementing highly sophisticated investment strategies, which generate consistent, large returns regardless of the gyrations of equity and debt markets.
These amazing characteristics, of course, come at a price—hedge fund managers are notorious for charging fees which are linked to the performance that they generate, generally 2% of assets under management, and 20% of any upside.
In financial markets, when something looks too good to be true, unfortunately it usually is. A number of financial economists have been taking a closer look at hedge fund returns, and have found that they are highly correlated with equity and bond markets.
The reason this isn’t immediately apparent is that this exposure tends to be hidden in the tails of hedge fund returns. More simply, the returns of many hedge funds resemble the returns to a strategy of selling insurance against a crisis event. In any period in which a catastrophe does not occur, insurance providers perform extremely well, taking in premiums from customers.
However, when the catastrophe does occur, the insurance provider is faced with a sudden, large payout. Analogously, when markets are tranquil, all is well, but when they crash, hedge fund returns are likely to be extremely low.
This is because their returns are often generated by selling crash insurance. Specifically, hedge fund returns are highly correlated with the returns to out-of-the-money put options on equity indices.
Of course, although this crash insurance is extremely common, not all hedge funds are the same. Managers pursue strategies as dissimilar as convertible arbitrage (taking advantage of pricing discrepancies between convertible bonds and the underlying equity of firms); merger arbitrage (betting on the probability that firms announcing mergers will see them through to completion); and pairs trading strategies (which seek to benefit from convergence in the prices of ‘twin’ stocks, potentially in the same industry), to mention just a few. However, there is one remarkably robust finding which holds, regardless of the specific hedge fund strategy under scrutiny: It is possible to replicate a large fraction of hedge fund returns using publicly available instruments such as stocks, bonds, currencies, commodities and options, in some combination. Several academic studies put this ‘replication percentage’ at between 75% and 85% of hedge fund returns. This means that hedge fund managers are often being paid large sums for investment strategies that would be cheaper to do-it-yourself (DIY). This observation has sparked off a rush by investment banks such as Goldman Sachs and JP Morgan to produce ‘clone’ indices, which replicate the average returns to hedge fund investments, using such DIY strategies.
At this point, scepticism is probably warranted. If hedge fund returns are so easily replicable, and their managers are doing nothing that generates value in excess of easily replicable trading strategies, then why has everyone been making a fuss about them? Two academics at the London Business School (William Fung and Narayan Naik), one at Duke University (David Hsieh) and I set out to investigate this question. The answer is that there are a few truly talented hedge fund managers (approximately one-fifth of the total number of funds that we analysed). These hedge funds are less likely to be liquidated than their less talented counterparts i.e. the business risk of investing in them is lower. They are also capable of consistently generating high, non-replicable returns, year after year.
While this is definitely good news if you are a prospective investor, the bad news is that sophisticated investors are very good at spotting these talented hedge funds. They inundate these funds with more money than they can handle. We discovered that total capital flows to the outperforming hedge funds dwarfed those to the replicable hedge funds, by a factor of three over the last decade. This wall of money had negative consequences for the star performers. Outperforming funds that received relatively high capital inflows struggled to generate future non-replicable performance. This last finding is unsurprising if you think that there are real constraints on the capacity of managers to come up with good ideas, and realize that mispricing in capital markets disappear once capital is committed to benefit from them.
So what’s the takeaway? The first bit of advice for prospective hedge fund investors is caveat emptor. You might be paying extremely high fees for easily replicable strategies that are available far cheaper. At the very least, it may be wise to pay attention to how the hedge fund under consideration has performed in relation to equity and bond indices. Second, even if you have spotted an unusually good investment vehicle, you should be aware that before too long, others will spot it as well—which will make it less attractive in the future. Finally, none of this means that there aren’t some genuinely smart investors out there; it’s just that the search for them is hard, and even when you have found one, you should constantly reassess your investment.
The author is a faculty member in finance at the Said Business School, and lead academic of the India Business Centre Initiative.
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