In Defense of the Hedge Fund Industry

Is the hedge fund industry undergoing an existential crisis? In this post, I argue that the dismal performance of hedge fund managers during the post-crisis period should not be attributed to a lack of hedge fund manager skill, but rather to the fundamental reorientation of the profile of the hedge fund industry and the unprecedented actions of central banks.

From Soros’ landmark bet against the British pound in 1992 to John Paulson’s big short against the US housing market in 2007, hedge funds have long attracted the covert admiration and suspicion of politicians, regulators and the public. The hedge fund industry has transformed from a small asset class catering to wealthy individuals into a major player in the global economy. The impressive performance of hedge funds amid the bursting of the Internet bubble resulted in an influx of institutional capital into hedge funds, which radically transformed the hedge fund industry. As Mallaby notes, “hedge funds grew larger, slicker and more methodical in style. They were emerging as a real industry.”[1] The ability of hedge funds to skillfully navigate the financial crisis of 2007-2008 further enhanced the reputation of hedge fund managers as savvy investors offering downside protection in extreme market circumstances. As of the first quarter of 2016, total assets under management for the hedge fund industry stood at $2,736.6 trillion.

Despite the constant growth of the hedge fund industry, hedge funds have, since the financial crisis, constantly underperformed equity markets throwing their reputation for delivering market-beating returns into doubt. The underperformance of hedge fund industry has raised doubts regarding the value offered by the hedge funds with critics pointing to the high fees earned by hedge fund managers and the superior returns offered by lower cost passive index trackers. Indeed, major institutional investors, such as the California Public Employees’ Retirement System, have decided to cut back their exposure to hedge funds while hedge fund managers are trying to repair the industry’s tarnished reputation.

Nevertheless, the criticism towards the hedge fund industry and the fears regarding its death are overblown. Most notably, as Getmansky et al. document, even though the absolute returns of hedge funds have declined during the post-financial crisis period, their risk-adjusted returns have remained strong.[2] The authors attribute the decline in absolute returns to the lower volatility of hedge funds’ returns post-crisis. Indeed, hedge funds responding to the risk-aversion of their investors traumatized by the experience of the financial crisis, are deploying lower amounts of leverage. The post-crisis underperformance of hedge funds on an absolute basis has been accompanied by a reorientation of the industry’s profile and investment style with hedge fund managers stressing their ability to offer their investors long-term stable investment returns. The increased allocations of institutional investors, which place diversification above outsized returns, have significantly contributed to this shift. 

Furthermore, hedge fund managers have been battered by the unprecedented interventions of central banks in financial markets. In their quest to combat low inflation and anemic growth, central banks in developed economies have massively expanded their balance sheets by engaging in a series of unconventional monetary policy measures involving the purchase of government and corporate bonds. The actions of central banks have artificially inflated equity markets, thus boosting the popularity of passive equity vehicles, which seek to replicate the performance of an underlying equity index. Moreover, the often confusing central bank policies are exerting a powerful influence on financial markets leaving hedge fund managers at the mercy of central bankers’ actions.

Overall, despite the recent subpar performance of hedge funds, hedge fund critics should not turn a blind eye to the fundamental shifts occurring both in the hedge fund industry itself and in financial markets more generally.

Alexandros Seretakis (SSRN author page) is a Teaching and Research Assistant and PhD Student at the University of Luxembourg.