Why Hedge Funds Underperform

To understand the hedge fund industry, it's important to know why some hedge funds underperform

Why Hedge Funds Underperform

An index of hedge fund performance, according to calculations by research firm HFR, gained just 0.81% in the first half of 2018. That was less than half of Standard & Poor 500-stock index’s 1.67% gain, per the New York Times. Two kinds of hedge funds dragged down the average performance: quantitative funds, which use complex trading algorithms, and long-short funds (sometimes known as market-neutral funds), which take both bullish and bearish positions in stock.

But why do hedge funds fail in the first place? Below are some of the most common reasons.

1. High fees

Studies show that historical compensation contracts in the hedge fund industry, such as the 2% management and 20% performance fees, are not effective at aligning managers’ incentives with investors’ interests. Chengdong Yin’s 2016 research, for example, shows that the management fee comprises a larger portion of total compensation when funds grow large and thus a fund’s optimal size, from a compensation perspective, exceeds the size that is optimal for performance.

Book author Sebastian Mallaby expressed a similar sentiment. For him, the 20% performance fee as incentive for hedge fund managers has declined in importance as assets have grown so large. He even suggested that institutional investors should now insist the hedge funds reduce their management fees.

Due to these high fees, hedge funds have sometimes been derisively described as "wealth transfer machines," moving assets from the hands of investors to the pockets of hedge fund managers.

2. The industry has expanded

Over the last 20 years, the hedge fund industry has increased its assets from $100 billion in 1997 to $3.2 trillion at the end of 2017. Additionally, while there were once only a few hundred fund managers, there are now thousands.

The whole point of hedge funds is to generate excess returns on investment, known as alpha, but the growth of the industry has impeded its ability to do so. Actively managed portfolios are the best at generating alpha, however the high number of fund managers has diluted the talent pool.

Because these gains are achieved by taking advantage of market inefficiencies, the industry's growth also increases the likelihood that different managers will be exploiting the same inefficiency, diminishing returns.

3. Unequal distribution

Hedge fund performance is not normally distributed – outliers successfully capture massive excess returns while the rest of the industry is made up of expensive, below-benchmark funds. The outliers tend to be overstated with regards to the overall industry’s performance, causing investors to be overconfident when investing in hedge funds.

4. Increasing fund size

There is an inverse relationship between the size of a successful fund and the manager’s ability to achieve alpha. As hedge funds become successful and more money flows into them, their ability to continue outperforming expectations diminishes. According to one study, hedge fund performance typically peaks during the first few years of a fund’s life but declines at an average rate of 42 basis points per year afterwards.

The decline in performance, according to the study, is tied to the fact that "fund managers may have lower incentives to improve fund performance because most of their compensation comes from the management fee, which only depends on fund assets." Additionally, some fund managers try to force the additional money by chasing trades that are less than profitable.

5. Poor decision making from investors

Institutional investors need to confront their own biases when choosing a high-cost fund manager. Many investors pick funds that underperform over the long term, causing more money to be allocated to poor-performing funds. Rather than looking at the past performance of a fund, investors should look at a fund manager’s process in picking investments. This is because processes are a better indicator of funds that will perform well in the future than previous performance.

Despite many hedge funds failing to perform to expectations, the money keeps rolling in. Why do hedge funds continue to be so successful in selling their "underperforming" products, especially to public pension plans? The answer is this: those who manage pension plans and pools of assets put money into hedge funds based on expected returns, rather than actual performance.