Performance for many hedge funds has significantly improved, and everyone seems happy. Hedge fund managers are happy because asset flows have stabilised or are increasing. Endowment and pension plan sponsors are happy because they can again show positive returns to their boards. The investment banks and exchanges are happy because hedge funds are their biggest trading clients.
I hate to spoil the party, but the fact that hedge funds’ returns have improved is actually bad news. In the short-term, of course their renewed performance is good news. However, their recent performance makes the longer-term outlook more negative for both the hedge funds industry and hedge fund as an asset class.
There are several reasons why hedge funds’ recent improved performance is bad news.
First, the hedge fund industry remains one with tremendous excess capacity. There are simply too many hedge funds, and the recent performance is likely to stymie the industry’s much needed consolidation. For hedge fund investors, anything that deters hedge fund consolidation is bad news because it will make it more difficult for their managers to have an original investment strategy that might generate “alpha” (i.e., returns that are manager-driven rather than market-driven). The continued scarcity of alpha will probably once again lead hedge funds to shorten investment time horizons, to speculate more, and to attempt to increase leverage to drive outperformance.
Hedge funds have long been marketed as “uncorrelated” assets, but that has not been true for the overall asset class for quite some time. My own earlier research demonstrated that correlations were rising between most common classifications of hedge funds and stocks, and that many so-called “uncorrelated” asset classes were actually increasingly correlated to the S&P 500. Hedge funds performed poorly when the S&P 500 declined, and have been performing well as the S&P 500 recovered. The current improvement in the performance of both hedge funds and stocks supports the point that hedge funds remain highly correlated to stocks, and are not a diversifying asset class.
The attribution of many hedge funds’ performances during the decade shifted from manager-driven “alpha” to market-related “beta”. The funds’ superior performance relative to the S&P 500 was often driven by the increased use of leverage rather than by superior research and stock selection. Recently, a prime broker told me that his firm was offering 14-15x leverage to their best hedge fund clients despite that most credit conditions had tightened. Investors need to again question whether hedge fund returns are again being driven more by leverage than by stock selection.
Thus, the improvement in hedge fund performance isn’t good news to me. The performance rebound seems to show that the funds remain highly correlated to stocks, and continue to use leverage as a significant driver of returns. When one combines those aspects with the lack of needed consolidation within the hedge fund industry, it makes one wonder why hedge fund investors don’t simply borrow money and invest in an index fund. The after-fee performance would probably be better.
Importantly, Treasuries remain about the only negatively correlated asset class to stocks. Despite the investment debacles that have riddled the past year, most investors have remained underweight Treasuries (except the Chinese). These investors, therefore, remain significantly under-diversified, and their portfolios continue to have significant unanticipated risk. The longer-term prospects in Treasuries still seem brighter to me than are those in hedge funds given this backdrop.
There are indeed some exceptional hedge fund managers I’ve met during my career, but they are actually quite rare. These few will not only survive, but their businesses will prosper and they will continue to provide superior and uncorrelated returns for their clients.
However, the problem seems to be that most investors have yet to understand how rare such managers are, and that a levered or collared index fund might outperform most hedge funds, and do so more cheaply. Sadly, the current rebound in hedge fund performance is likely to reinforce the widespread misconception that there is something advantageous to investing in hedge funds.
Richard Bernstein is CEO of Richard Bernstein Capital Management LLC. He was previously Merrill Lynch’s Chief Investment Strategist and Head of the Investment Strategy Group. He has written two books on investing: Navigate The Noise: Investing In The New Age Of Media And Hype and Style Investing: Unique Insight Into Equity Management.