The past few years have been rough on hedge funds. Some have done very well, such as the Medallion Fund, a highly mathematical quant fund operated by Renaissance Technologies. It has produced returns averaging over 30% since its founding in 1988, totaling approximately $55 billion in profits, making multimillionaires of many of its very fortunate investors, who for the most part are professional mathematicians and others employed by Renaissance.
For most other hedge funds, it has been a different story, namely year after year of subpar performance. For example, the HFRI Equity Hedge (Total) Index of U.S. equity hedge funds was up only 4.85% as of the end of November 2016 (from 1 January 2016), with an annualized return over the past 5 years of only 5.15%. This compares to a 12.06% annualized return for the S&P500 index (14.30% with reinvested dividends) over the same five-year period ending 30 November 2016.
Not surprisingly, many hedge fund clients are not happy. In 2014, the California Public Employees’ Retirement System (CalPERS), which is the largest U.S. pension fund, announced that it would completely exit its USD$4 billion investment in hedge funds. In April 2016, the New York City public pension fund announced that it will also exit all hedge fund investments. Finally, in December 2016 the New Jersey Investment Council voted to cut in half its USD$9 billion hedge fund holdings.
In total, over USD$51 billion was withdrawn from U.S. hedge funds over the first nine months of 2016. Similar troubles have beset hedge funds in Europe and Asia.
In the wake of these withdrawals, many hedge funds have closed. In the first quarter of 2016, more U.S. hedge funds were liquidated than started. Tudor Investments, led by billionaire Paul Tudor Jones, laid off 15% of its workforce, in the wake of over USD$2 billion of investor withdrawals. Howard Fischer, head of Basso Capital Management, lamented “It’s miserable, miserable.” George Papamarkakis, head of London’s North Asset Management (which declined roughly 10% in 2016), lamented “There’s gloom everywhere.”
Not surprisingly, hedge fund managers’ woes have elicited little sympathy from clients. As New York City’s Public Advocate Letitia James told members the board, “Let them sell their summer homes and jets, and return those fees to their investors.”
Hedge fund fees
Many are questioning the traditional hedge fund fee structure, typically a “2-20” rule: a 2% annual fee, plus a performance fee of 20% on any profits. These fees are, of course, far higher than the fees typically charged by conventional mutual funds, not to mention the rock-bottom fees of popular index-tracking mutual funds and exchange-traded funds (ETFs). BlackRock’s iShares IEUR ETF, which tracks the MSCI Europe IMI index, charges an annual fee of 0.10%. Vanguard’s VOO ETF, which tracks the S&P500 index, charges 0.05%. Neither ETF has a performance fee.
But as a recent article in the New York Times points out, effective hedge fund fees are often even higher than the 2-20 rule would lead one to believe, due to quirks of accounting. For example, the NY Times article cited a letter to investors by Bill Ackman, who disclosed that in the four years since his Pershing Square Holdings fund was formed, it had gained a total of 20.5% (decidedly mediocre given that the S&P500 gained 67% over this period) before fees, but only 5.7% after fees. In other words, over the four-year period, the fund management kept approximately 72% of the fund’s profits.
The difficulties can be illustrated by considering the fate of a USD$1 million investment in a fund that generates 10% in the first two years, and then loses 5% in the next two years. Before fees, the investment would be USD$1.092 million at the end of the fourth year, for a 9% gain. But after deducting a 20% performance fee in the first two years (and zero performance fee for the last two years), the investment would be at USD$1.053 million, or in other words a total return of just 5.3%.
But even this calculation, which was cited in the New York Times, does not include the 2% annual fee assessed by many hedge funds. If one recalculates the above with a 2% annual fee deducted after each year’s close, then the result is as follows: $1.058 million after year one; $1.119 million after year two, $1.042 million after year three, and $0.970 million after year four. In other words, although the investment gained a profit of 10% before fees, the 2-20 fees erased all gains and left the client with a 3% loss.
In light of these experiences, many, both within and without the hedge fund industry, are questioning the traditional 2-20 fee structure. Some funds have already reduced the 2% annual fee to as low as 0.7%. Others in the industry are arguing that a hedge fund should not assess any fee whatsoever in years that it loses money, and only a minimal fee if it fails to meet its benchmark. One way or another, the hedge fund industry is changing before our eyes.
As we have pointed out in a previous Blog, these results should not come as a surprise. After all, markets by definition incorporate the collective judgments of many thousands of highly trained market analysts worldwide, who employ sophisticated mathematical algorithms running on powerful supercomputers to ferret out any regularities or correlations, and then use high-frequency trading algorithms to act on these phenomena in real time (not to mention millions of other corporate and individuals investors). The efforts of these many players largely cancel each other out, leaving a time series that is little more than a random walk.
It could be argued that some pockets of opportunity existed in the 1980s and 1990s, when computer technologies were scarce and some agents were more informed than others. But in today’s world, those informational asymmetries are largely absent, and so are most of the easily exploitable opportunities. As George Papamarkakis of London’s North Asset Management explains, “There are only so many market inefficiencies out there to profit from.”
Along this line, it should also not come as a surprise that the few remaining hedge funds that do make a respectable gain above the larger markets tend to rely on highly sophisticated mathematical algorithms, along with massive computer databases and processing power. The Renaissance Medallion Fund, mentioned above, reportedly employs very sophisticated techniques, although the details, as one might image, are carefully guarded secrets. A few other funds also do well, but these might be the effect of survivorship and selection bias, rather than management skill.
In any event, let us not be surprised that even relatively sophisticated hedge funds have difficulty achieving consistently above-market returns. After all, they are betting against a signal that is almost entirely random noise, and then charging a premium fee.