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Hedge funds and the active management crisis
Active management and hedge funds have suffered what amounts to a mini-meltdown in recent years as ambitious client expectations have collided with complex market conditions and slow, tectonic shifts in the finance landscape. James Bianco, CFA, president of Bianco Research, recently argued at this year’s 60th CFA Institute Financial Analysts Seminar in Chicago that a changing interrelationship between the stock and bond market alongside a plague of high correlations was responsible for recent weak performance of hedge funds and active managers.
“In short, hedge fund performance as a group has been a complete disaster over the past five years,” Bianco said. “So, to earn the standard 2% and 20%, and outperform the index, managers have to be extraordinary. The problem is that there are probably only about 500 extraordinary managers in the world, but there are 11,000 hedge funds.” Active managers have also fared badly. “Over the past 10 years, 76% of active managers underperformed,” said Bianco, “It has been a struggle for most investors to understand how these relationships have changed.” Passive investment is increasingly the default response to such investor confusion.
Performance – No Excuses
While this year has been an embarrassing one for many hedge funds, longer term data suggests most hedge fund indexes perform better than stock and bond indexes and have lower volatility, according to one paper, “European Hedge Funds Industry: An Overview,” summarized in CFA Digest. The European hedge fund industry often outperforms in various strategies and rivals that in the United States, thereby giving investors access to global talents and strategic locations.
Writing in the Journal of Index Investing, Benjamin McMillan of Van Eck Global, in another paper summarized in the latest CFA Digest, asks the question: When does active management add value? McMillan says that, contrary to what other authors claim, actively managed long-short equity hedge funds (currently the largest industry strategy) actually tend to earn negative alpha during periods of market instability. Furthermore, much of the outperformance many equity managers often claim is alpha can be explained as factors, according to Eugene Fama, Kenneth French, and fellow researchers. This seems to leave any remaining alpha attributable to some combination of momentum, fund cash management, and luck rather than any easily attributable skill. Tough times indeed for active managers and their marketers.
More and more absolute return funds are seeing their exposures cloned when drivers of performance can be isolated and replicated. A Comprehensive Guide to Exchange-Traded Funds (ETFs) by Joanne M. Hill, Dave Nadig, and Matt Hougan identified 29 ETF-based absolute return clones and suggested that many hedge funds “lend themselves to factor-based approaches that can be offered within the ETF structure for competitive fees.” That said, the guide also points out that strateg