Question:

Rene Stulz compares hedge funds to mutual funds.

(i) From the perspective of performance, why is the comparison difficult?
(ii) Citing research, Stulz generally affirms both hedge fund alpha ("positive insignificant alpha after fees” on average, with demonstrable alpha for above average funds) and, even more clearly, superior risk-adjusted returns. What enables hedge funds to produce superior results (several reasons given)?
(iii) What future does Stulz predict for hedge funds?

Answer:

(i) Why is performance assessment difficult?

Stulz gives four reasons for the difficulty in assessing hedge fund returns:

1. BIASED SAMPLES. Hedge fund performance reports are based on biased samples. Databases can only report funds that voluntarily report their performance (self selection). Further, there is SURVIVORSHIP BIAS: funds that liquidate tend to be excluded. (In a correct sample, they would be represented as zeros.)

2. HARD TO ADJUST FOR BETA EXPOSURES.  “A fair estimate of hedge fund returns must adjust performance for market exposures,” says Stulz. This refers to the difficulty in correctly itemizing the beta exposures; if a beta exposure is omitted, it will tend to be reveal (incorrectly) as alpha.

3. HARD TO ADJUST FOR RISK EXPOSURES, especially in regard to “black swans.” Stulz example is writing catastrophe insurance: until the catastrophe occurs, the strategy may generates stable fee income and the risks may not be revealed in the historical window. The recent credit crunch provides similar examples. For example, writing credit default swaps (i.e., short CDS, long the reference assets) generates premium income; if default is highly unlikely, under a short time window, the strategy may appear to be relatively safe.

4. HARD TO VALUE (perform valuation): “many derivatives are traded over-the-counter. For securities not traded on an exchange, no closing price exists. A hedge fund may need to rely on theoretical models to estimate the value of some securities, or rely on quoted prices rather than actual transaction prices”

(ii) Superior performance

In regard to hedge fund performance, Stulz finds “at the very least, hedge funds have a non-negative alpha net of fees on average. Another way to phrase this conclusion is that hedge fund managers earn at least their compensation on average. The debate in the literature centers on two points: the size of the average alpha and the persistence of the alpha of individual funds.” But perhaps more compelling is that for the study period (Jan 1994 to mid 2006), the hedge fund index produced a similar return to the S&P;500 (10.8% annualized versus 10.3%) but with almost one-half the volatility (7.8% vs. 14.5%); therefore, their Sharpe ratio was almost double.

Several justifications for outperformance can be put forward based on the Stulz paper:

1. Flexibility to pursue absolute return strategies: the ability to (i) short, (ii) use leverage, and (iii) use derivatives
2. Related, while relative returns cannot deviate much from a benchmark, absolute return strategies do not need to “hug a benchmark.”
3. Smaller size means less capital to deploy to alpha-generating strategies
4. Asymmetric incentive fee structure (e.g., 2% fee plus 20% carried interest) arguably attracts top talent
5. Stulz cites investor liquidity as a performance factor: “Investors in mutual funds typically can withdraw funds daily. This means that mutual funds have to stand ready to redeem shares, which typically decreases their performance as they have to have low-earning cash on hand. It is risky for them to invest in strategies that may take time to prove profitable because adverse developments in the short run may lead investors to take their money out. Hedge funds have rules that restrict the ability of investors to withdraw funds and, usually, investors can withdraw funds only at specific times during the year.”

(iii) Future of hedge funds

* As more money chases a finite amount of total alpha (i.e., estimated value-weighted alpha of 4% per year), the average alpha per hedge fund will decrease
* As a larger fraction of assets under management (AUM) comes from institutions, Stulz predicts an institutionalization of hedge funds: institutional investors will demand risk management and risk reporting; better reporting; increased tendency to measure against benchmarks. The upshot prediction is that hedge funds will shift a bit to resemble mutual funds with more similarity of performance across styles. Also, he predicts manager skill will diminish in importance as other services are elevated (reporting, risk management)
* Hedge fund replication (see Lo’s Paper) on the rise
* As hedge funds become successful, they will resemble diversified financial institutions
* Mutual funds will increasing compete with hedge funds as they can implement some of their strategies