[The link here Hedge Fund (Absence of) Performance will take you to the paper direct but if you’re a CFA Charterholder you’ll fine the same in your latest edition of No Life Monthly (P.109) a.k.a. The Financial Analyst’s Journal.]
Researchers Nicolas P.B. Bollen, Juha Joenvaara and Mikko Kauppila revisit a now familiar, and proven beyond all doubt, fact i.e. that Hedge-Funds don’t work in terms of providing superior risk-adjusted returns. At one time and long ago they may have (there’s contention about even that), but in recent years they haven’t.
The paper adds usefully to the literature as to why this has happened and, of more interest, how even now they may still have a place in large diversified portfolios.
Practitioners can read the paper in full so for the casually curious I’ll summarize only very briefly. Why have they stopped working?
Two reasons. First, there has been a clear “..decreasing returns to scale at the industry level.” problem. In short there are too many people with too much money trying to skin the same cat.
The second problem is the bigger headache. The researchers note two distinct periods in their work, before the GFC and after. After the GFC governments got more involved in markets, notably in the U.S. with the passing of the Dodd-Frank reforms. The researchers observe this has created a financial environment “..inhospitable to many hedge fund strategies ..[And] … To the extent that these effects are likely to persist hedge funds in aggregate may not be able to achieve the same level of success going forward that fueled their rise in the mid-1990s…”
Unlike previous studies that end with the conclusion Hedge-Funds are not worth investing in now based on return characteristics this paper proceeds to a more constructive aside.
Although return superiority evaporated around the time of the GFC some diversification benefits of including them in a broader portfolio have persisted. [The paper provides some pointers on how to select the better ones].
So, don’t buy Hedge-Funds for superior returns in future but for large and diversified portfolios the asset class still may offer (selectively) diversification benefits (but will not reduce your Sharpe ratio it should be noted, an important point for wonks to think on).
Happy Sunday.