Eugene F. Fama once said, “I can’t figure out why anyone invests in active management, so asking me about hedge funds is just an extreme version of the same question. Since I think everything is appropriately priced, my advice would be to avoid high fees. So you can forget about hedge funds.”Source.
It’s quite a punchy statement, is it not? Especially in a world where we regularly read articles in major news journals about the incredibly talented managers who, at different times, have outperformed the market (you know their names: from algorithmic trading legends like Clifford Asness of AQR and Kenneth Griffin of Citadel, to charismatic activists like Bill Ackman, Paul Singer, Daniel Loeb, and others).
These popular articles often miss the fact that many successful funds have long since transformed into family offices and no longer accept external money, or they have a pool of institutional investors who were fortunate enough to recognize their talent before it became mainstream. Typically, such funds have a large queue of investors waiting to get in and a high entry threshold for initial investments, often measured in tens or even hundreds of millions of dollars.
So, what can those who also want to join in on the fun do? One route is to turn to intermediaries like private banks, which can facilitate investments in prominent funds for additional fees. Alternatively, try their luck with lesser-known funds, where the promise of above-market returns is anything but certain.
Or, if you’re up for some irony, you could dive into the "beautiful" world of modern financial science, steeped in statistical methods, and explore insights Eugene Fama understood long ago.
For those curious to go deeper, take a look at the meta-analysis “Where Have All the Alphas Gone? A Meta-Analysis of Hedge Fund Performance” by Fan Yang, Tomas Havranek, Zuzana Irsova, and Jiri Novak. Source. They have done crucial, painstaking work consolidating and analyzing the hedge fund market based on 74 empirical studies (1,019 independently calculated alphas) published from 2001 to 2021. If you have the time, it’s worth diving into this 57 - page academic paper, complete with statistical tables and insights. If not, no worries — we at GreenLock have pulled out the key takeaways for you:
1. Increased Capital Inflow
In recent years, capital inflows into the industry have grown, likely due to hedge funds’ reputation for better risk management.
2. Gross Alpha vs. Net Alpha
Funds tend to publish their gross alpha without accounting for investor costs in fees. When fees are included, the excess returns diminish significantly (shocker, I know).
3. Alpha Decay Over Time
Researchers noted a consistent decline in hedge fund alphas over time.
And, fanfares, the most important insight:
4. Post-2015 Alpha Collapse
While hedge funds may have generated abnormal returns in the past, since 2015, the average current one is not reliably different from zero. Moreover, the results show negative alphas if hedge funds are broken down by typical categories according to their investment nature and benchmarked accordingly. Fund of funds exhibits negative alpha at a 95% confidence interval.
If this wasn’t enough to dampen your spirits, here are additional findings on research design characteristics that affect excess returns, as identified by the authors:
5. Alpha Reductions with Data Adjustments
Alpha declines when adjusting for database backfill and survivorship biases.
6. Complex Models and Alpha
Alpha decreases significantly while authors use multifactor models instead of the general CAPM.
7. Bear Market (Under)Performance
Hedge funds, on average, surprise-surprise, generate negative alpha during bear markets, which completely undermines their claims of superior risk management.
Remember at the start when I mentioned how investors are offered access to hedge funds through intermediaries like private banks and others, with added layers of fees? Why pay extra for something unlikely to bring any value in the first place?
Sergey Borzenko
COO, GreenLock AG
