A friend brought my attention to a recent article in the FT by James MacKintosh in which he noted how hedge funds have increasingly been delivering returns that are correlated with the S&P500. It looks as if increasingly the search for alpha includes trying to time beta. The media isn’t normally so negative on hedge funds – perhaps Mr. MacKintosh has looked at the website for my book.
One of the problems with selecting hedge funds is that so few of them consistently outperform their peers. Manager selection is really the only way to justify a hedge fund portfolio. If you can’t pick funds with skill then it’s best not to bother, because average hedge fund returns have trailed treasury bills . An investor can be a passive investor in equities through mutual funds and need not possess any security selection skill to justify exposure to the assets class. The same cannot be said for hedge fund investors.
But the challenge of picking good managers is compounded by the fact that returns mean revert. For the vast majority of funds, not every year is a good year. I did some analysis earlier this year for my book using data from BarclayHedge. Suppose your objective is to pick managers in the top 40% – seemingly not exactly a tall order you might think. However, of those managers that are ever in the top 40% only 7% are able to stay there for every year of their existence. The best managers have mediocre years. Whereas an equity investor can try and exploit mean reversion and sell his winners to reinvest in that year’s underperformers, such an option doesn’t easily exist for the hedge fund investor given the lengthy time involved in due diligence. And hedge fund managers who concluded this was their clients’ strategy would quickly tire of such a flighty investor, perhaps refusing to take them back.
It’s not that hedge funds are all bad – and indeed the hedge fund industry has generated fantastic results. It’s just that those results haven’t really made it back to the investors who provide the capital. Hedge fund investors need to do better than they have.