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The Return Experience of Hedge Fund Investors
Ilia D. Dichev and Gwen Yu
Hedge funds have enjoyed spectacular
growth over the last 15 years. However,
the returns of hedge funds and the returns of investors in the funds can be
drastically different.
What is the real return of
hedge fund investors?
Hedge funds have enjoyed spectacular
growth over the last 15 years, climbing from
about $30 billion of assets under management in 1990 to about $2 trillion in assets in
recent years. There are a number of reasons
for this success but undoubtedly the most
important one is hedge funds’ apparent ability to deliver superior returns accompanied
by reduced volatility1. Proponents of hedge
funds point out that the superior performance is possible due to their lightly regulated status, and the ability to use unconventional investment assets and strategies,
including investing in illiquid assets, taking
short and market neutral positions, and taking bets on event arbitrage, etc.
However, there is also some reason for
skepticism about hedge fund’s actual investor returns. Hedge funds operate in highly
competitive markets, where information and
trading advantages are unlikely to be maintained for long. As hedge funds themselves
proliferate, chasing the same investment
opportunities is likely to yield diminishing
returns. Thus, it seems unlikely that hedge
funds can continue to deliver appreciably
higher and consistent returns on a wider
scale. Especially as hedge funds grow and
mature, their returns are likely to revert to the
mean, implying mediocre performance for
the greater mass of investors, who joined the
funds only later.
In a recent study, we suggest a specific
way to operationalize this intuition by distinguishing between the returns of hedge funds
and the returns of investors in the funds. A
widely used return metric to gauge hedge
fund performance is the buy-and-hold return
calculated as the geometric average of fund
returns over the specified time period. Note,
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however, that this metric only measures the
return for a passive investor who joined the
fund at inception and held a constant stake
throughout. In contrast, the real return of the
actual investors can be drastically different
from the return of the fund because most
investors join and leave the funds in uneven
bursts of capital flows. We measure investor
returns by using dollar-weighted returns,
which fully reflect the effect of the timing
and magnitude of capital flows. The upshot
of our study is that evaluating the real-life investors’ returns after considering the capital
flow weights portrays a very different picture
of the returns from investing in hedge funds.
Example of dollar weighted
returns.
The intuition about dollar-weighted returns
and their difference from buy-and-hold returns is best illustrated using an example
from the hedge fund industry. Consider the
experience of the Orbis Optimal Fund, which
has a fairly common market-neutral strategy.
Selected annual data about Orbis are given
in Table 1, specifically assets-under-management (AUM), annual returns, and annual capital flows in and out of the fund.
An examination of Table 1 reveals that
the Orbis fund has generally prospered during the sample period, starting in 1990 with
assets-under-management of less than $100
million and finishing with almost $4 billion
in 2005. This increase in asset base is partly
due to respectable returns with an average
of about 12 percent per year but even more
so to investor contributions, which average
over 14 percent of beginning assets per
year. There is also considerable variation in
realized returns, where the fund starts with
strong returns in the early 1990’s, the returns
are at best mediocre in the mid to late 1990’s,
outstanding returns in 2000-2002, and then
the returns subside again in 2003-2005, a
pattern counter-cyclical to that of the broad
U.S. equity market. The pattern of returns is
strongly mirrored in the pattern of investor
capital flows, with heavy inflows in the early
successful years (capital inflows are more
than 50 percent of assets-under-management in 1991 and 1992), a slowdown and
actual heavy redemptions of capital in the
following years, a resurgence of heavy capital
contributions in the early 2000s, and signs of
a slowdown towards the end of the sample.
A comparison of the pattern of returns and
capital flows reveals a classic picture of investor flows chasing performance, with investors
piling in when returns are good and leaving
during periods of poor returns.
Note that this pattern of capital flows and
returns also signifies poor investor timing,
where investors increase their capital exposure just before subsequent poor returns and
reduce their capital commitment before superior future performance. Thus, for investors
as a class, the actual returns from investing in
Orbis are likely to be lower than the widely
calculated buy-and-hold return. The reason is
that buy-and-hold assumes an equal weighting of returns over time; in contrast, investors
have a highly uneven capital exposure over
time, and therefore intuitively a proper measure of the investors’ actual realized returns
has to somehow reflect that. Dollar-weighted returns, computed
using an internal-rate-of-return (IRR) calculation, takes into account
the capital exposure and their timing by viewing the investment as a
capital project defined by all relevant capital flows. Essentially, dollarweighted returns are returns that are value-weighted not only in the
cross-section of returns but also over time.
In the example of Orbis, this difference is indeed large. The annualized buy-and-hold return over the 1990-2005 sample period is
11.32 percent, respectable on an absolute basis and exceeding the
S&P 500 benchmark value-weighted return of 10.85 percent over the
same period. However, the dollar-weighted return is only 8.10 percent, more than 3 percent lower than the buy-and-hold return. The
magnitude of this difference implies that the effect of capital flows
can be not only material but could be actually a decisive determinant
of actual investor returns. The dollar-weighted return is also lower
than the S&P 500 benchmark, indicating that the typical investor in
Orbis ended up doing worse than with a simple index-fund strategy.
Broader evidence of hedge fund investors’ returns
In the published study, we provide large-sample evidence of the return experience of investors in the hedge fund industry. Using data
of over 10,000 hedge funds that operated between1980 and 2008,
we find that the return experience of hedge fund investors is much
worse than previously thought.
Specifically, our finding shows that annualized dollar-weighted
returns of an average hedge fund are on the magnitude of 3% to 7%
lower than corresponding buy-and-hold fund returns. Using factor
models of hedge fund returns, we find that the real alpha of hedge
fund investors is close to zero. More surprisingly, the dollar-weighted
returns are reliably lower than the return on the Standard & Poor’s
(S&P) 500 index, and are only marginally higher than the risk-free rate
(as of the end of 2008).
In evaluating an investment strategy, it is always important to
consider the alternative, i.e., the returns the investor would have
achieved had he or she invested in another asset class. For example,
what would be the returns of the hedge fund investor if they had
deployed their capital instead in the S&P 500 during the same time
period? We thus compute a hypothetical dollar weighted return of
the hedge fund investors, using hedge funds’ pattern of capital flows
combined with the return of the S&P 500. The exercise reveals that
the dollar weighted returns of hedge funds and the hypothetical dollar weighted returns of the S&P 500 are remarkably similar (9.7% and
9.3% respectively). In other words, if the hedge fund investors had
instead invested in another Index fund during the time period, their
returns would not be all too different.
Future of hedge fund performance
The recent financial turmoil in the late 2008 caused havoc in the
hedge fund industry. Most hedge fund indices showed an unprecedented drop in returns and for the first time in hedge fund history,
the capital flows into the industry showed net withdrawals2. The recent crisis period vividly illustrates the strong correlation between the
industry performance and the capital flows into and out of the industry. Investors continue to withdraw capital following large losses and
September - October 2011
Table 1
Year
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
Selected annual data for the Orbis Optimal Fund
Market
value (AUM)
98,600,000
210,300,000
457,700,000
681,600,000
680,400,000
825,000,000
1,011,200,000
712,000,000
477,400,000
431,600,000
734,600,000
1,078,200,000
1,498,000,000
2,499,100,000
3,692,900,000
3,978,000,000
Mean
Buy and hold return 1990-2005:
Dollar weighted return 1990-2005:
BNH Return
Distributions
.
.
0.2569
0.2006
0.1046
-78,307,180
-191,768,240
-163,367,590
5,630,860
-34,541,350
-152,593,490
209,631,830
297,236,540
60,756,410
-157,735,530
-120,843,480
-278,656,220
-810,159,380
-1,134,460,570
-261,690,640
0.0087
0.1675
0.0397
-0.0931
0.1137
0.0293
0.3264
0.2902
0.1214
0.1083
0.0225
0.0823
0.1186
Distributions
/AUM
.
-0.5070
-0.5742
-0.2868
0.0083
-0.0459
-0.1662
0.2433
0.4998
0.1337
-0.2705
-0.1333
-0.2163
-0.4054
-0.3664
-0.0682
-0.1437
0.1132
0.0810
AUM is assets-under-management. BNH Return is buy-and-hold return. Distributions is
the signed capital flows during the year, and is computed from the change in assets-undermanagement during the year, controlling for the realized returns. Capital flows are
computed using the formula: Distributionst = AUMt-1*(1 + rt) - AUMt, where rt is the
buy-and-hold return for period t, and Distributionst is the signed capital flow for period t,
where a positive distribution signifies capital outflows (investor redemptions) from the
fund, and negative distributions signify capital inflows (investor contributions) to the fund.
to pour in more capital after large gains. This implies that the returns
realized by the investors will tend to fall short of the widely publicized
buy-and-hold returns publicized of the funds. Without understanding
this difference, hedge fund investors will find it challenging to properly assess their risk profile and the commensurate returns.
This article is based on the article ‘Higher risk, lower returns: What
hedge fund investors really earn', published in the Journal of Financial
Economics 100 (2011) 248–263.
About the authors
Ilia D. Dichev is the Goizueta Professor of Accounting at the Goizueta
Business School, Emory University. He has taught financial accounting
classes at all student levels at Rice University, University of Michigan,
and Emory University. His research interests are in the areas of equity
valuation, quality of accounting earnings, and market efficiency. He
has published in most leading journals in accounting and finance and
is the recipient of several research awards.
Gwen Yu is an assistant professor of business administration in
the Accounting and Management Unit at Harvard Business School.
She teaches the Financial Reporting and Control course in the MBA
required curriculum. Her research focuses on how accounting information affects various real economic outcomes. Professor Yu holds a
Ph.D. in accounting from the University of Michigan, where she also
earned a master’s degree in applied economics. Her undergraduate
degree is from Yonsei University in Seoul. Before pursuing her graduate studies, she worked at McKinsey & Company and the global reinsurer Swiss Re.
Notes
1. For example, the CISDM Hedge Fund Index has an annualized return of 15.13% with a
standard deviation of 6.97% over 1990-2005, which compares well with the S&P 500 index
that show a return of 10.55% with a standard deviation of 14.32% over the same period.
2. Hedge Fund Research, 2008
www.worldfinancialreview.com
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