If Hedge Funds Are The Smart Money, Why Doesn’t It Feel That Way?

Undoubtedly, hedge funds are the smart money in investment management. Despite mounting criticisms around fees, genuine alpha and sustainability, they have delivered higher risk adjusted returns versus their long-only cousins over the long run.

But why doesn’t it feel this way? For institutional investors, it’s as if a cloud of skepticism had recently settled on them, most notably after 2008. Apart from the fact that it’s natural for such skepticism to emerge during bull runs (we’re in an equity bull market for 5 years now), data indicate that something truly fundamental has changed. Let’s take a look at equity ideas traded by HFs for example.

Consider the performance of the Novus Hedge Fund Universe (HFU), a long-only portfolio which tracks the value-weighted returns of positions held by  over 1,000 hedge funds over the last decade. The portfolio is a good representation of what hedge funds own in aggregate. We have simulated performance assuming managers rebalance their portfolio at filing date. From March 2003 until December 2014, the Novus HFU outperformed the S&P 1500 by 81 percentage points (301% for Novus HFU vs. 220% for S&P 1500), equivalent to an annualized alpha of 170 bps (see Figure 1). However, the majority of alpha was generated before October 2007. At that point in time, the Novus HFU had outperformed the S&P 1500 by 51 percentage points (154% for Novus HFU vs. 103% for S&P 1500), generating an annualized alpha of 300 bps (also see Figure 1).

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When comparing the Novus HFU vs. the S&P 1500 from October 2007 onward, no alpha was generated (see Figure 2).

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What does this tell us? And most importantly, what’s the implication for institutional investors? The conclusion is that hedge funds – as a group – did not generate alpha on the long side post Oct 2007. In other words, aggregate alpha for hedge funds is gone. Thus, investors ought to dig deeper to find outperformance, through either better manager selection or by following the best ideas of the most skilled managers out there.

Manager selection explains why the fund of hedge fund industry struggles. It’s not because there aren’t skilled managers out there. It’s because putting together a portfolio of managers does not guarantee out-performance; and fund of hedge funds – let alone few notable exceptions – have not created an edge in manager selection. Most of the process still revolves around the old adage of screening returns, meeting the manager, investing after outperformance and divesting after underperformance (actually detracting performance). The alternative? Define what investment skill means to you invest in an internal technology infrastructure or find a reliable partner like to provide you with an efficient way to gather and normalize data and perform the analytics. Only such an investment in data and technology will translate into superior manager selection. Allocators large and small rely on Novus for data aggregation and skill set analysis. Some use the data for selecting skilled managers, others use it to gain exposure to hedge fund risk factors like conviction, bypassing direct HF investment all together.