Study Dispels Myth That Hedge Funds Always Outperform Stocks And Bonds

by Phillip Morton, Investors Offshore.com

09 June 2006

Most investors can achieve similar performance in a properly diversified portfolio of stocks and bonds as they can in the average Hedge Fund of Funds, according to a newly-released historical analysis of hedge fund investment performance.

In its report 'Demystifying Hedge Funds II', Presidio Financial Partners LLC, a San Francisco wealth management advisor, compared the performance of a diversified portfolio of investments to the HFRI Fund of Funds Composite Index, the industry benchmark for HFOFs.

The study found that from April 2000 - at the height of the equity bull market - to March 2006, the diversified portfolio generated an average annualized return of 6.3%, compared to 5.2% for the HFRI Funds Index. The period analysed included the bear market of 2000 to 2003, when many investors poured money into hedge funds.

According to Presidio's findings, over a longer period, from January 1990 to March 2006, the same pattern of investment returns was repeated. The diversified portfolio of investments generated an average annualized return of 10.6%, compared to 10.1% for the HFRI Funds of Funds.

The model diversified portfolio in Demystifying Hedge Funds II was designed to replicate the typical asset allocation of many individual and institutional investors and consisted of the following: 40% taxable bonds (Lehman Aggregate Index), 20% US large cap (S&P 500), 10% high yield bonds (ML Lynch High Yield Master II), 15% international equity (MSCI EAFE), 10% US small cap (Russell 2000), and 5% emerging market equity (MSCI EMF index).

The analysis ignored factors that have historically lowered hedge fund returns, including the differences in tax efficiency and the quality of the data for the HFOF index, such as survivorship bias, backfill bias, and index methodology.

Jeff Spears, Managing Director of Presidio, explained that the study results are not intended to dissuade individuals and institutions from hedge funds, which he argued remain an important component of a total asset allocation strategy.

“The point is that as hedge funds become more popular, investors need to proceed with caution," he noted.

"Finding the top performing funds is exceedingly difficult, but there are hedge funds that are absolutely worth the additional fees and risk," he added.

The study concluded that only 12 to 15 of the more than 1,000 HFOFs – and no more than 250 of the more than 8,000 individual hedge funds – deliver performance in line with their higher fees.

There are several reasons for this, according to Presidio. A major factor is that outside the top-performing hedge funds, managers are often "mediocre to poor." Also, most HFOF personnel lack the sophistication to comprehend complex hedge fund strategies, and instead gravitate toward easy-to-understand strategies, such as long/short equities, merger arbitrage, and convertible bond arbitrage.

Furthermore, while sophisticated HFOFs place a strong emphasis on risk management, both qualitatively and quantitatively, most HFOFs have inadequate or no risk management systems, the study concluded.

Another reason for the poor performance by HFOFs is an apparent lack of flexibility to change the hedge funds in which they invest, therefore forcing them to be wedded to hedge funds that are "well past their prime".

Presidio says that it typically recommends HFOFs rather than single hedge funds for investors with less than $10 million to invest in hedge funds.

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