Hedge Funds Fail

New Study Reveals Funds Are More Passive Than Active

Hedge Funds Fail
September 29, 2015

What are hedge funds, and why are they so revered by some and hated by others? Hedge funds are simply pools of money from specific investors designed to outperform the market through alternative investment strategies.

Hedge funds involve higher risk, and thus participation is limited to accredited investors who have a net worth of over $1 million, a minimum income level, and some investing experience and knowledge. That gives hedge funds the deserved reputation as being a vehicle for the rich, part of the reason they elicit strong feelings one way or the other.

The higher risk comes via using active strategies to maximize the return. Use of futures, short positions, leveraged purchases, derivatives, and alternative securities allow hedge funds to multiply gains — or losses. Active management and correct forecasting are crucial to stay ahead. Hedge fund managers charge higher fees, typically two and twenty (2% of assets in management fees and 20% of profits), in return for more active management and correct insight.

However, hedge funds as a group have performed poorly in recent times. According to The Economist, the average hedge fund returned 3.3% in 2014 while the S&P 500 increased by 11.4%. A new paper by Mikhail Tupitsyn and Paul Lajbcygier of Monash University in Australia may explain why hedge funds are underperforming.

The paper charges that the majority of hedge funds are actually passive in their behavior, yet found that the more passive funds tended to outperform the active ones — and neither one performed as well as more market-neutral funds. In essence, most hedge fund managers cannot beat the market, especially in periods of prolonged growth. They just are not as good at correctly identifying the proper high-risk opportunities.

Over the study period from 1994-2010, hedge funds deemed as passive had average returns 0.1% lower than neutral funds, while active hedge funds had 0.28% lower average returns. Poorer performance with higher risk and volatility is a bad combination.

The time horizon is an important parameter in the analysis. According to the paper, in the short term, hedge funds tend to engage in "dynamic trading strategies involving complex securities," but over the long run, they develop passive behaviors. Given these returns, it is understandable how hedge funds can naturally drift toward passive behavior. Only the most skilled of active managers can consistently produce in the high-risk sector, and those with less skill and/or luck are forced to accept a more passive strategy to survive.

Statistics on hedge fund performance back up this claim. The paper finds that only 15%-20% of funds that start active stay active through periods of poor performance. Meanwhile, 70%-85% of funds with a more passive strategy in the beginning stay with that strategy.

While active and passive are subjective terms, the paper uses a thorough statistical analysis to classify the funds according to what the authors call linear and non-linear risk exposures. Linear risk exposure contains proportionate risk according to reward, while non-linear risk exposure amplifies the effect, whether gains or losses. Leverage is a good example of non-linear behavior, where buying with borrowed money amplifies the return (you can invest more money than you actually have) and the risk (you can lose more money than you actually have).

Hedge funds tended to fall into distinct types. Arbitrage, managed futures, and event-driven strategies were primarily non-linear and active, and emerging markets, long-short equity, and dedicated short bias funds were more linear and passive.

The bottom line: just because a fund is called a hedge fund does not mean that it consistently takes the active, high-risk high-reward approach. Make sure that the higher fees you are paying for active hedge fund management are actually going toward active management and that the management is producing significantly higher returns over the long run. If not, why would you bother with a hedge fund at all?

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Angie | 09.29.15 @ 14:01
I knew very little about hedge funds other than their name - probably because I'm so far from the minimum requirements to be allowed to invest in them?
Elaine | 09.29.15 @ 14:04
I have heard the term hedge fund but never really knew anything about its purpose. Thanks for sharing, now I know a little more.
Steffanie | 09.29.15 @ 14:04
Didn't know all this about hedge funds. Very interesting.
Daniel | 09.29.15 @ 14:09
I seem to feel i have heard nothing but bad news about hedge funds though admittedly it is not something i researched much as it was not a fit for me
Nancy | 09.29.15 @ 14:10
I have heard the term but never understood what they were. The required Yuri requirements to participate would never allow me to be a part of this type of investing.
Carla | 09.29.15 @ 14:10
I've often wondered what the term "hedge fund" meant. It sounds like a very risky investment.
Erin | 09.29.15 @ 14:12
Thank you for the information. I feel a little bit smarter now!
Sarah | 09.29.15 @ 14:14
Nice info. Not something I will be using but interesting nonetheless.
Wanda Langley | 09.29.15 @ 14:28
I have heard the name Hedge Fund but I did not know this much about it. Thanks for the info.
Kaila tubbs | 09.29.15 @ 14:30
Interesting information, I have heard the term a few times but dont have close to the money to have one.
Sara | 09.29.15 @ 14:30
Never heard of hedge funds until now. Very interesting concept. I can see why I have never heard of it since I am no where near able to invest in them.
Chrisitna | 09.29.15 @ 14:38
Hedge funds are too risky for me at my age, and I have the world's worst luck ;)
Leslie | 09.29.15 @ 14:43
This is an excellent explanation of hedge funds and how they work. Even if I could afford to invest in one, I think they're a bit to risky for my taste.
irene | 09.29.15 @ 14:44
Great info, I honestly never knew what a hedge fund was.
Britt | 09.29.15 @ 14:47
I didn't really know much about hedge funds before this article.
Debbie | 09.29.15 @ 14:49
Had no idea what a hedge fund is and now I do. Thank you for the information in a way that I can understand it.
Alec | 09.29.15 @ 14:49
I'd heard the term hedge fund but didn't know what it was. It sounds a lot like playing the stock market with higher stakes than ever. It's not something I'd invest in even if I met the requirements. I feel there are better options with more payout and less risk.
Kyle | 09.29.15 @ 14:50
Lots of very good information here.
Ron | 09.29.15 @ 14:52
Hedge funds are the cool kids tables of investing, it seems. I prefer a set it and forget it approach, but I check in every quarter regardless and adjust as needed.
Kailie | 09.29.15 @ 14:53
I have heard the term thrown around a bit, but never knew what it was. This was a lot of great info.
Bobbie | 09.29.15 @ 14:58
I never bothered to look into them because of the minimum threshold, and it looks like I'll never have to bother. It looks so risky and seems like the only one making money is the manager.
Heather | 09.29.15 @ 15:00
Whenever I heard the term it was always in a negative way. Thanks for giving us the facts about what it really is.
STOKES | 09.29.15 @ 15:00
Hedge funds aren't even something I think about. I couldn't be much further from the minimum income level.
Kamie | 09.29.15 @ 15:12
The returns from a hedge fund is not good, so I am not sure why others would put the risk in it.
Rychana | 09.29.15 @ 15:28
I've never used a hedge fund. This is a great article
Selena | 09.29.15 @ 15:32
I've only heard the term before. Didn't know a single thing about them.
Crystal | 09.29.15 @ 15:45
This is the most I've ever read about hedge funds beyond the scandals. Great info!
Jo Ann | 09.29.15 @ 15:48
Hedge funds are extremely confusing to me, but the risk doesn't seem to out weigh the potential for any considerable profit. I would not put my money there if I had that kind of money.
Apryl | 09.29.15 @ 15:51
Interesting read in spite of being no where near the min. requirements.
Christina | 09.29.15 @ 15:53
I wondered what a hedge fund was about. Good information.
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