White paper points to ‘meaningful reduction’ in active bets and alpha since financial crisis
The 2008 financial crisis appears to have been a crucial inflection point in the history of hedge funds — specifically, it could have marked the end of their success in achieving alpha.
A new paper from the University of Virginia’s Darden School of Business, titled Hedge Fund Alpha: Cycle or Sunset?, has found that risk-adjusted excess returns for hedge funds have averaged -0.8% over the last 10 years. It marked a “strong decline” from the 15-year period preceding the crisis, during which the average hedge fund manager was able to add 3.4% in net risk-adjusted returns.
Author Rodney Sullivan, executive director of Darden’s Richard A. Mayo Center for Asset Management and former vice president of AQR Capital Management, repeated the analysis by focusing just on equity hedge funds, and obtained similar results.
“Even though reports pointing to poor hedge fund performance often incorrectly compare them to an all-equity benchmark, as we’ve seen, the more accurate market-risk-adjusted performance of hedge fund managers is also clearly not good,” Sullivan wrote.
Sullivan then examined hedge-fund exposures to stock-market risks, bond markets, and other possible contributors to risk-adjusted excess returns. He found that while hedge funds’ aggregate exposure to market risks has been “relatively consistent,” they are drifting closer to their passive benchmarks as they take on much less active risk relative to the pre-crisis period.
Exactly what has caused the apparent deterioration of active risk among hedge funds is not clear, though Sullivan identified several possible reasons. One possibility is that hedge funds are able to find fewer alpha opportunities in the post-crisis period.
An increase in the number of hedge fund firms and assets under management, he said, could also have diluted arbitrage effects as more managers and assets seek opportunities. From having just US$200 billion in AUM around the turn of the millennium, he said that the industry has grown to exceed US$3 trillion in assets managed.
“Finally, perhaps clients of hedge funds post-GFC simply sought lower active risk from their active managers, and in turn asset managers obliged,” Sullivan said.
He theorized that the shift could have been driven by a lower threshold for risk after getting burned during the crisis. Hedge funds could also be catering to more high-net-worth individuals, pension plans, and other clients with lower-than-typical risk appetites.
