Fair value - If we are going to be critical of hedge funds then it will be for the right reasons


Ian Kelly

Ian Kelly

Fund Manager, Equity Value

The hedge fund sector has been attracting a fair degree of flak in recent months and, here on The Value Perspective, we do not mind admitting this saddens us. Partly this is because most of the current hedge fund-bashing is being done for wrong reasons but mostly it is because other – far more valid – reasons for criticising the sector do exist.

The main reason hedge funds are being attacked is because they have failed to keep up with equity markets over the course of the extended bull run – now five years and counting – that the likes of the S&P 500 in the US have been enjoying. How can the average hedge fund have returned less than 10% in 2013, the arguments have run, when the S&P 500 managed a shade over 25%.

That, of course, is to misunderstand the point of hedge funds – a big clue to which can be found in their name. Hedge funds use various investment strategies in a bid to produce absolute – as opposed to relative returns – across all market conditions rather than just during raging bull markets. If they succeed, their investors should do very nicely on a compound basis.

As such, it would be wholly wrong to expect hedge funds to perform in line with, say, the S&P 500. Indeed that leads to one valid criticism of the sector that we highlighted last year in Handy maths  – how average hedge fund returns were growing increasingly correlated with broader equity markets, thereby providing less of a ‘hedge’ for investors.

Now, where one might reasonably expect hedge funds to outperform is versus a portfolio of equities and bonds so let’s put that to the test. We built two portfolios – both with 60% in a global equity ETF and the balance of 40% in either an intermediate government bond ETF or an investment-grade corporate bond ETF – and compared them with the Credit Suisse Hedge Fund Index.

This, Credit Suisse assures us, “was the industry's first – and remains the leading – asset-weighted hedge fund index” and, while the group does not mention how many other asset-weighted hedge fund indices are out there as competition, it does go on to explain: “Asset-weighting, as opposed to equal-weighting, provides a more accurate depiction of an investment in the asset class.”

To feature in the index, a fund must have $50m (£30m) assets under management, a minimum one-year track record and current audited financial statements so it may well contain some survivorship bias. In other words, since – as this FT Alphaville article shows – two-thirds of the hedge funds that have ever been launched no longer exist, the data is more forward-looking than it otherwise might be.

Nevertheless, the index does provide a useful measure of the average performance of a hedge fund and indeed, within that, Credit Suisse also offers a breakdown of the average performance of a number of different strategies such as ‘global macro’, ‘event-driven’ and so forth. Most of these will use some sort of multi-asset approach to investment.

So how then has the average hedge fund – and, as ever, we would stress this is only an average – fared against our two 60/40 portfolios? As the graph below shows, the government bond portfolio did exactly as well, with similar ‘drawdowns’ – that is, peak-to-trough declines – in 2008 and 2009 and a similar end result. For its part, the corporate bond portfolio outperformed hugely in relative terms.

Fair value chart

Source: Bloomberg as at 29 April 2014
Past performance is not a guide to future performance. The value of investments and the income from them can go down as well as up and investors may not get back the amount originally invested.


None of which necessarily proves hedge funds are poor investors – it could, for example, simply mean charging 2% a year and a 20% performance fee destroys much of the returns. The moral you can draw from this story, however, is that you should bash hedge funds not for underperforming the equity market but for underperforming a reasonable alternative passive investment strategy.

As a postscript, we would suspect that, although it still has the best part of four years to run, Warren Buffett could be feeling quietly confident about the $1m ‘Long bet’ he made with a hedge fund manager back in 2007 that, over 10 years, the S&P 500 would outperform a portfolio of funds of hedge funds, net of fees and expenses.


Ian Kelly

Ian Kelly

Fund Manager, Equity Value

I joined Schroders European equity research team in 2007 as an analyst specialising in automobiles. After two years I added the insurance sector to my coverage. In early 2010 I moved into a fund management role, and then took over management of two offshore funds investing in European and Global companies seeking to offer income and capital growth. 

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Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.