Hedge funds have had a tough decade. Over the last ten years to the end of October 2013, the HFRX measure of hedge fund returns delivered just 12 per cent versus 105 per cent for the S&P 500 equity index and 62 per cent for world government bonds. For investors expecting big things for the fees they pay, this is hard to stomach. It’s not all bad news though because with careful sifting, highly effective strategies can be identified and go on to serve investors well. The starting point, however, has to be a recognition that the hedge fund universe as a whole probably cannot meet the high expectations demanded of it.

These expectations take the form of three broadly recognised deliverables, namely strong absolute returns, a smooth “ride” and low correlations to wider markets. Taking the first, many hedge funds now openly admit they cannot gain an edge in an environment of low interest rates and government intervention. Instead, the industry and its new institutional client base are increasingly concentrating on the second two aims of low volatility and low correlations to wider asset classes, i.e. a more modest “cash plus-plus” offering. This is sensible repositioning and such characteristics would still be valuable, albeit less attractive, commodities in portfolios today. But the question remains whether even these less ambitious aspirations can be achieved consistently.

Smooth risk-adjusted returns have always been perceived as a traditional hedge fund strength. Key to producing these has been the ability to keep any drawdowns as brief as possible by staging swift recoveries from any setbacks. For example, the HFRX Macro/CTA index went on to perform after each of its ten worst months for performance during the last decade. While one of these tough months - August 2007 - did see a strong subsequent recovery by the hedgies, the rest did not. Unlike bonds, which generally do have an inviolable pull to par when the borrower repays the debt at the end of the term , hedge funds are only as good as the skill of their traders in limiting volatility and reversing losses in a fast-changing investment environment.

Diversification and low correlations to wider markets form the third plank of the hedge fund pitch, literally the “hedge” part of the name. This also goes to the heart of the way many funds organise themselves, shaping the strict risk budget policy many top houses impose on their traders. These risk budgets are the investment management equivalent of the New York City taxi medallion, representing a licence to do business within the Darwinian world of hedge fund trading. This has to be earned from small beginnings but, as trust and ability are demonstrated, the best traders are rewarded with more client money to invest.

Results

The results of this risk management discipline are clear to see; from the end of 1989 to the end of 2007, just before the financial crisis, the HFRX Global Hedge Fund Index produced a flat to positive return in 38 out of the 79 months in which the S&P 500 equity index fell. This equates to an enviable “defence rate” of nearly 50 per cent and a very tangible characteristic the industry can point to. But 2008 onwards is a different story. The sample size is obviously smaller, but the proportionally adjusted results are dramatically worse. Of 28 monthly drawdowns posted by the S&P 500 index from the start of 2008 to end October 2013, the HFRX was able to post a flat or positive return during just five of them. This is a defence rate of just 18 per cent, compared with 46 per cent for world government bonds.

All this would amount to quite an indictment of hedge funds but investors should consider whether they ask too much of the sector. For example, being able to demonstrate low correlation and diversification when traditional asset classes sell off can sometimes be at odds with the demand for swift performance recovery. It is not hard to imagine a situation in which equities suddenly fall after a rally and those hedge funds that had participated immediately cut their positions in order to preserve low correlation on the downside. If they do this, then they have defended well and satisfied the low correlation and diversification requirement.

But to then go on and stage the kind of quick recovery that is so vital to creating a strong, smooth performance profile often requires re-engaging in the very same asset class they have just sold out of. But not all is lost. Of the 6,000 operators that make up the hedge fund universe there will always be some who really can consistently deliver for their clients. Finding the next George Soros is a tough call but wealth managers with dedicated research resources can still help clients identify funds capable of delivering.

And market conditions could be turning more favourable too. Recently there have been signs that dispersion, the rocket fuel of hedge fund performance, might be coming back into markets. One vivid example in recent months has been the divergence in monetary policy between the US and Europe. The Federal Reserve will eventually taper its asset purchases but the UK has reiterated its commitment to ultra-loose monetary policy while the ECB cut its repo rate in early November. The ensuing opportunity bears a passing resemblance to the recent yen carry trade in which hedge funds effectively borrowed in low interest rate Japan and invested in virtually any higher-interest rate asset class to generate healthy risk-adjusted profits on the difference. 

As the different components of the world economy recover at their own pace this is just the kind of opportunity that may yet put hedge funds back on their feet.