Hedge Funds: The Elite Investors Who Struggle to Outperform the Market

Hedge funds manage a massive amount of capital allocated to their investment vehicles, totaling over $3 trillion globally as of 2018. Their investors include internal employees, the ultra-wealthy, pension plans and many more. Broad interest and significant capital inflows reflect the growing desire and faith in hedge funds to produce outsized returns and minimize risk. However, conflicting narratives have cast uncertainty around hedge funds’ capacity to achieve impressive returns. On one hand, many argue that hedge funds possess an unfair competitive advantage and thus can generate abnormally high returns for their wealthy clientele - allowing the rich to get richer. However, hedge funds have also come under scrutiny for their expensive fees and underperformance relative to the market. These arguments are both prevalent and completely at odds with each other. Which argument holds more truth? Are hedge funds overpowered investors who have an unfair advantage that allows them to enrich themselves and their wealthy clients, or do they simply charge exorbitant fees while delivering lackluster returns which pale in comparison to the market itself? 

When critics argue that hedge funds fail to outperform the market, they often refer to hedge fund indices that conglomerate the performance of a variety of hedge funds, and then benchmark them against typical measures of market performance, such as the S&P 500. These include the Eurekahedge Hedge Fund Index, which amasses data from over 2,000 hedge funds in a variety of regions and measures their performance together to give a general representation of how hedge funds are performing. There is no shortage of hedge fund indices, some of which track hedge funds broadly, while others focus on region or strategy. In many cases, the indices underperform, or at best, keep up with the broader equity market’s returns. This comparison is often the primary driver of criticism, since it would seem hedge funds charge their high fees (usually a “2 and 20” structure, 2% of assets under management and 20% of profits above a hurdle rate) while simultaneously delivering unexciting returns.

While there is some merit to comparing hedge fund indices to broader market performance, this method often fails to capture the complexity of the industry. The prototypical hedge fund is a discretionary long/short fund, meaning it picks stocks using its own fundamental analysis to initiate either a long or short position. If all hedge funds operated this way, with no mandate other than going long on the best stocks and short on the worst, regardless of industry or size, then comparing their performance to broad markets may be perfectly accurate. In reality, discretionary long/short funds make up only one portion of all hedge funds, and they often have industry or size mandates depending on the assets they manage. The list of hedge fund strategies is unlimited as managers seek new ways to deliver returns. Hedge funds that pursue different strategies will have completely dissimilar operations - for instance, an activist short fund will look nothing like a fund which specializes in litigation finance. This differentiation illustrates why comparing their performances to typical equity benchmarks may be misguided. Some hedge funds invest purely in credit - why would it make sense to compare their performance to stocks? To get an accurate performance indicator, one must select a benchmark that reflects the fund’s strategy and risk profile, as this would be more indicative of relative performance to peers. Such a practice, however, would prove incredibly difficult given the opaqueness of the industry.

Although it is relatively inefficient to roughly approximate the performance of hedge funds using indices and compare them to the market, this argument is in no way a defense of hedge fund performance. These funds do fail, and often lose a lot of money or “blow up,” meaning they shut down permanently. In the 2008 crisis alone, more than a thousand hedge funds blew up. Further, even if they manage to keep their doors open, hedge funds can lose vast sums of money in any given year on bets that will haunt their returns for years to come. Bill Ackman, once dubbed “Baby Buffett,” lost over $4 billion dollars on his investment in Valeant Pharmaceuticals, which turned out to be involved in fraudulent business practices that sent the stock tumbling from over $250 to a low of just over $11. Even as his hedge fund, Pershing Square, posted a return of over 70% for 2020, the loss lingers over its cumulative performance. Hedge funds have also blown up extraordinarily quickly, even as they manage billions in assets. Amaranth Advisors managed to lose $5 billion in a week on an asset base of under $10 billion by using excessive leverage and making an illiquid bet on energy contracts. The firm employed over 300 people and its demise resulted in many job losses. These are just a few examples of an endless list of hedge fund missteps. The average hedge fund only has a lifespan of just about five years, indicating that many struggle to continually deliver strong risk/return profiles. 

Making a definitive claim about the performance of hedge funds is difficult, primarily due to the fact that no two funds are alike. There are examples on both sides of the coin: outperformance and underperformance. Even though hedge funds have frequently been lumped together and shamed for underperformance, the massive capital inflows they continue to receive demonstrates a resilient confidence in their work.