More Evidence of Hedge Fund Futility
Somehow I missed this report of a study of hedge fund performance over the period 1980 through 2008. It is sobering and shows the average hedge fund did a lot worse than an investment in the S&P 500 index. Steven Goldberg, contributing editor to Kiplinger did a good job of summing up the report by Ilia Dichev, Emory University and Gwen Yu, Harvard Business School:
A forthcoming paper in the Journal of Financial Economics found that from 1980 through 2008, the average hedge fund returned an annualized 6.1% after fees.
How bad is that? By contrast, Standard & Poor’s 500-stock index returned an annualized 10.8% over that same stretch. If you had simply invested your money in three-month Treasury bills, you would have earned 6.2% annualized.
But that’s not the worst of it. Co-authors Ilia Dichev of Emory University and Gwen Yu of Harvard not only looked at raw returns for hedge funds but also determined how much the average dollar invested in hedge funds actually returned.
Take a fund that returns 10% in year one, then loses 5% the following year. The fund’s reported, or time-weighted, return would be 4.5%.
But if you really want to know how much investors earn you must look at dollar-weighted returns, which adjust for the amount of assets in a fund over time. Using the above example, suppose the fund had $1 million in assets during the first year. Then investors, impressed with the first year’s performance, send more money to the fund and assets average $2 million during the second year. In this case, the dollar-weighted return — the return on the average buck — would be a big, fat goose egg. “Dollar-weighted returns reflect the actual experience of real-life investors,” the professors write.
How did the average hedge-fund dollar do? It earned 2.9%, the study found — less than half the reported return of the hedge funds themselves.
Reason: Investors flooded into hedge funds after they had done well. “We found massive returns-chasing,” says Dichev. “There is return-chasing in mutual funds, but in hedge funds it’s much more pronounced.” (A Morningstar study cited in the paper found that dollar-weighted returns for stock mutual funds trailed the funds’ reported returns by an average of 1.5 percentage points per year.)