Reports of the demise of hedge funds returns have not been greatly exaggerated
Hedge funds continue to attract huge quantities of assets, their hypnotic charm working its magic on everyone from pension funds to retail investors. In the last year alone $129bn went into the asset class, double the previous year. Yet recently there have been rumbling sounds in the distance - the warning signs of an investment trend that is about to peak in popularity and slump in performance.
In fact, the slump has already happened. The five-year average return for single-strategy funds is only 7.70%, according to Edhec-risk Asset Management Research. For the retail-friendly fund of hedge funds universe the situation is even worse, with an average five-year return of 5.65% pa - just 65 basis points higher than the yield offered on an ING Direct savings account.
One source of trouble seems to be the sheer number of hedge funds that have come into existence. The number of active hedge funds has quadrupled in the last 10 years from roughly 2,100 in 1995 to over 8,000 in 2005, according to research done by the Hennessee Group, a hedge fund advisory firm in New York. The impressive returns that were possible when there were only a handful of managers using these strategies are simply no longer realistic in a saturated market.
"With so many hedge funds attempting to extract return from the market, everyone is after the same trade," says Dr Harry Kat, director of the Alternative Investment Research Centre (AIRC) at the Cass Business School in London.
So it is clear that many investors are bound to be disappointed by their hedge fund holdings but that does not mean that they cannot play a valuable role in a diversified portfolio. Even though their returns may not be stellar for the forseeable future, the asset class is still potentially very valuable - through lack of correlation with other asset classes and lack of correlation between the various hedge strategies.
According to data from the AIRC, the average fund of hedge funds has a 15%-25% correlation with US equity and bond markets, while on the other hand correlations between the main strategy classes ranges from nothing to 44%. This was taken from a study completed four years ago, but there is no reason to suppose it no longer holds.
All these facts indicate that a fund of hedge funds would be the perfect investment proposition, as the low correlation between each strategy would produce a well diversified portfolio. But any positive impact this might seem to have on the case for funds of hedge funds is undermined by their poor performance relative to single strategy funds. In fact, as mentioned above, investors on average would have been better off buying a basket of all single strategy funds than they would paying a fund of funds manager to create a more focused portfolio.
What we can learn from all of this is that there is no free lunch with hedge funds. Perhaps investors should try to find another investment opportunity to be excited about. After all, there is a big difference between something that is good and something that is too good to be true.
Steve Gallo, Cass Business School
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