Hedge Funds

I recently stumbled across the FT Alphaville collection on hedge fund performance.

The latest, "The hare gets rich while you don't: back the passive tortoise" reviews a Nomura report covering the performance of "alternative investments," private equity and hedge funds. (The report is here, alas behind the FT's very confusing paywall.) A while ago I put together a class and talk covering hedge fund literature, but haven't updated it in a few years so reviews with updates are particularly interesting.

The fact that hedge funds and private equity have a lot of beta -- often hidden by infrequent or inaccurate marking to market -- remains true:

Source: Nomura via FT alphaville

"To achieve the returns of hedge fund portfolios:
1) start with basic market exposure using the S&P 500 index or a rolling short VIX position,
2) reduce leverage to achieve an exposure of somewhere between 30% to 60% of standard, and
3) deduct fees.

To achieve the returns of private equity:
1) start with a basic market exposure like the S&P 500, but more particularly the S&P Midcap 400, 2) increase leverage to achieve an exposure of somewhere between 120% to 150% of standard, and
3) deduct fees.

Which prompts a game of spot the difference.
Starting with the Vanguard S&P 500 fund, we de-leverage it (to achieve a 57% exposure, which is the beta of Protege Partners to the Vanguard S&P 500) and then deduct both fixed and performance fees. What we are left with is virtually indistinguishable from the performance of the Protege Partners fund of funds."

To me, the private equity results are novel -- though I suspect Steve Kaplan will disagree

I'm interested  by their finding that hedge funds do earn just enough alpha before fees to pay their fees. This fits the Berk and Green model in which investors get exactly the same return as in passive investments, more than the Fama and French view that there isn't any alpha in the first place and active investors are just being morons. Extending the Berk Green vs. Fama French debate to hedge fund data is low-hanging dissertation fruit.

Your favorite hedge fund manager will respond, "those results show the average hedge fund doesn't deliver anything to investors. But that's an average of good and bad funds. We're a good fund." Ah, but how to tell good from bad ex-ante, since they all say that? FT reminds us how little past performance tells us with a memorable anecdote:

Day to day, reporting spectacular bets that have paid off for individual hedge fund managers still makes for good stories about the hedge fund industry. But John Paulson did everyone a favour by being the genius of the financial crisis who made several fortunes betting agains mortgage backed securities only to then look like an idiot in 2011 when his flagship fund halved in value.

Selection bias is alive and well in private equity, or at least its marketing

To a large extent, private equity promoters are aware that there is some kind of performance problem in their industry. For this reason, marketing documents that we have seen describe the returns investors can achieve in private equity by referring to return data from the top quartile of private equity managers. This is done because the returns from a sample that included all private equity managers would not look impressive. 

For the statistically-minded, this practice is a whopper.

The rest of the series looks interesting too

NO ALTERNATIVE: THE ZOMBIE HEDGE FUND INDUSTRY SERIES

Two-thirds of all hedge funds ever to report to a database are dead and defunct, yet their investment record lives on and the industry is hungry for fees...

1. Return of the living dead, hedge fund edition
2. The great diversification bait and switch
3. Step one in zombie prevention: pants on
4. A managed futures smackback to the Bloomberg takedown
5. Another walking dead update
6. Zombies are the wrong kind of mean
7. Two and twenty is long dead and buried
8. Three things long/short hedge funds cannot do (well)
9. Smart enough to avoid a zombie bite?
10. Sour sixteen, a pre-Zombie update
11. The zombies have representation, and would like to respond
12. The world's most successful hedge fund is not a hedge fund
13. Can we finally lay to rest the idea that zombies justified their existence in 2008?
14. Pre-Zombie update
15. Zombie hordes thrive, await further hedge fund corpses
16. Pre-zombie update
17. Pre-zombie update: slow, steady and hungry they march
18. One in four lose some more
19. Most hedge funds fail
20. The hare gets rich while you don't. Back the passive tortoise