Hedge Funds: A Deeper Look into their Returns

Hedge Funds: A Deeper Look into their Returns

Despite the dismal results delivered to their investors since inception1, hedge funds have continued to grow, reaching a record $2.25 trillion by the end of 2012, according to Hedge Fund Research2.  At IFA, we have consistently warned investors to steer clear of them, and an article3 published two years ago in the Financial Analysts Journal reinforces our conclusions. The authors delved deeply into the problems with the returns reported by the commonly used hedge fund databases. First, as with most of the widely reported mutual fund data, the returns are infected with survivorship bias, the tendency for failed funds to disappear from the databases along with their historical returns, which are usually subpar. The second problem is known as “backfill bias”, and it arises from the tendency for successful hedge funds to begin reporting their returns, including returns received prior to the inception of reporting. Backfill bias is very similar to “incubation bias” for mutual funds which is extensively discussed in IFA’s Step 5: Manager Pickers. The chart below shows the returns of hedge funds after correcting for survivorship and backfill bias.


To see just how significant a problem survivorship bias is, the chart below shows that five out every eight hedge funds did not survive over the fifteen year period ending December 31st, 2009.


In addition to survivorship and backfill bias, a third problem with reported hedge fund returns was identified by Philippe Jorion and Christopher Schwarz of UC Irvine, the delisting bias, which is the tendency for failed hedge fund managers not to report their returns just before shuttering their funds. Jorion and Schwarz estimate that the performance of hedge fund indices should be adjusted downward by about 0.50% to account for this bias, and they calculate the hedge fund attrition rate to be 12.3% per year over the 1994-2008 period. Even if an investor is lucky enough to pick a hedge fund that survives for the duration, she still has to overcome the very strong headwind of the exorbitant fees charged by hedge fund managers, as seen in the chart below.


In light of these ridiculously high fees, a reasonable question for any hedge fund investor to ask is, “Am I getting my money’s worth?” The chart below would argue for a negative answer, seeing that 61% of hedge fund returns could have been replicated with simple, low-cost stock and bond index funds.


After all was said and done, the return received by a hypothetical investor who put an equal amount into each of the 6,169 hedge funds that existed on 1/1/1995 received an annualized return of 7.70%. Interestingly, this is about the same return as an investor in a low-cost S&P 500 Index fund would have received, and for a lot less grief in watching 63% of the hedge funds go belly up. However, as Simon Lack1 pointed out, when we look at total investor cash flows into hedge funds through the years, the story becomes much worse. Since hedge funds received the bulk of their in-flows in the later years when the returns were much lower, the overall returns received by all hedge fund investors were about the same as what they would have received in Treasury Bills, the quintessential risk-free investment. Lack found that since 1998, hedge fund managers have kept 84% of profits, leaving a paltry 16% for investors. Once again, we will repeat our admonition to investors to steer clear of The Sleaziest Show on Earth.

We have taken a deeper look at the performance of several other mutual fund companies and have come to one universal conclusion: they have failed to deliver on the value proposition they profess, which is to reliably outperform a risk comparable benchmark. You can review by clicking any of the links below:



1Lack, Simon, “The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to Be True”. New Jersey, 2012, John Wiley & Sons, Inc.

2”Relative Value Aribtrage Leads Hedge Fund Capital to New Record,” (HFR press release, January 18, 2013)

3Chen, Peng, Roger G. Ibbotson, and Kevin X. Zhu, “The ABCs of Hedge Funds: Alphas, Betas, and Costs,” Financial Analysts Journal 67, no. 1 (January 2011)