Hedge Fund Alpha: Cycle or Sunset?

Abstract

The hedge fund industry has grown from $200 billion in assets under management around the turn of the millennium to now over $3 trillion. Many reports have criticized hedge funds for poor performance, particularly since the 2008 Global Financial Crisis (GFC). In this article, the author seeks to demystify hedge fund strategies by evaluating fund performance that can be attributed to the markets as well as other well-known systematic factors with an emphasis on outcomes prior to and following the 2008 GFC. When adjusted for risk to stock/bond markets, the evidence shows that, after fees and costs, hedge fund managers as a group have shown a marked decline in risk-adjusted alpha in the 10 years following the GFC. To aid in a better understanding of the alpha deterioration, he further investigates equity hedge fund returns against a suite of well-known systematic risk/return factors documented in the literature beyond traditional market factors. In all, the model explains nearly 90% of the variation in returns. Equity hedge funds as a group show meaningful and consistent exposures to many of these factors over time, but whether intended or otherwise, significant changes also occurred (including a significant decline in active risk) following the GFC, in turn influencing their performance. Armed with this information, investors are hopefully better positioned to make more informed decisions in deciding hedge fund strategy allocations.

TOPICS: Mutual fund performance, factor-based models, equity portfolio management, financial crises and financial market history, performance measurement

Key Findings

• ▪ In the 10 years following the 2008 Global Financial Crisis (GFC), hedge funds overall (and a subset of equity-focused hedge fund managers) have witnessed a deterioration in alpha: declining 4.4% annually to −1.0% a year, on average, net of fees and costs.

• ▪ Results of a multi-factor model explaining up to 90% of excess returns variation show that hedge funds have meaningfully altered how they drive performance, partially explaining the observed change in results post-GFC.

• ▪ Equity hedge fund managers significantly reduced their active risk in the post-GFC period versus the earlier period, which is likely another important contributor to the decline in alpha over the past decade.