Which hedge funds actually beat the market?

Introduction

The last few years have been difficult times for hedge funds. For the majority of these funds, performance has lagged market averages, certainly not in keeping with the exalted fees charged by the fund managers. For example, as of 1 July 2017, the HFRI Fund Weighted Composite Index is up 3.28% year-to-date, and 4.79% annualized gain for the previous 5 years. The corresponding figures for the S&P500 Index (including dividends) are 9.34% and 13.6%.

These chronic performance shortfalls have led many clients to rethink their hedge fund investments. In 2014, the California Public Employees’ Retirement System (CalPERS), the largest U.S. pension fund, announced that it would liquidate its USD$4 billion investment in hedge funds. In April 2016, the New York City public pension fund announced that it will also liquidate all hedge fund investments.

Others are questioning hedge fund fees, typically 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 (as low as 0.05%) of popular index-tracking exchange-traded funds (ETFs).

As a result of these difficulties, in 2016 total hedge fund holdings declined by USD$70 billion, only the third net loss in history.

IIA’s Hedge Fund 100 rankings

Each year, Institutional Investor’s Alpha publishes its annual report on the performance of the top 100 hedge funds.

In their latest report, numerous large funds suffered sizable asset declines. These include Paulson & Co., which at one time was the world’s third-largest hedge fund (recall they made billions on their 2007 bet that the U.S. home mortgage market would collapse). In the wake of recent double-digit losses in several of its mainline funds, Paulson now ranks #69.

Other funds with large declines include Lone Pine Capital (now #19), Tudor Investments (#65), Capital Management (#29), Oct-Ziff Capital Management Group (#9) and others. Perry Corp., in the wake of several years of losses, no longer ranks in the top 100.

In spite of these liquidations and closures, however, there are still over 10,000 hedge funds in operation.

Do any hedge funds actually achieve market-beating returns?

So in the midst of all this gloom-and-doom, are there any hedge fund firms that actually make good money, achieving returns that significantly beat market averages, and are actually increasing in assets? Yes, as it turns out. Here are some:

  1. Renaissance Technologies (ranked #4). They now manage $42 billion in assets, up a whopping 42% from the previous year. According to IIA, Renaissance is arguably the most successful hedge fund firm of all time.
  2. AQR Capital Management (ranked #2). AQR’s assets increased by 48%, to $69.7 billion.
  3. Two Sigma (ranked #11). Their assets increased 28%.
  4. Bridgewater Associates (ranked #1). Bridgewater manages USD$122.3 billion, up 17% from 2015. Its Pure Alpha fund has achieved a 14.6% annualized return for the past five years.

In general, according to Institutional Investor’s Alpha,

Five of the six largest firms in this year’s ranking rely all or mostly on computers and algorithms to make their investment decisions, a theme that has increasingly played a role in the top-100 ranking over the past few years. And all five posted asset increases last year.

Conclusion

So it really is true that geeks are ruling the world? It sure seems so. At the least, these results are consistent with the “efficient market hypothesis,” in the sense of the difficulty of guessing markets based on present or past data. At the least, only very sophisticated mathematical techniques are likely to achieve “positive alpha” returns.

As we have pointed out in a previous Blog, 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 individual investors). The efforts of these many players largely cancel each other out, leaving a time series that is little more than a random walk.

Not so long ago, discretionary traders dismissed the idea that one day quantitative funds would rule the space. One argument was that quant funds were “black boxes”, models that recommend counter-intuitive trades, bets that nobody can understand. Ironically, that may be the reason for today’s quant hegemony: A counter-intuitive good bet is better than an intuitive one, because the former is less likely to be crowded. In other words, a black box does not have to share the profits with millions of individuals, all reading the same Wall Street Journal articles. Furthermore, the number of possible black-box models is combinatorially enormous, thanks to the explosion of data sources, Big data, machine learning and high-performance computing.

In any event, we should 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.

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