Hedge funds vs. fixed income

So much has been said and written about hedge fund performance lagging the performance of stock markets. But as most hedge fund advocates will point out, this is an unfair comparison since hedge funds are designed to provide stable returns, not high returns. When stock markets are down, hedge funds may be up or at least losing less than equities.

That is well taken, but in practice, most institutional investors haven’t invested in hedge funds as a replacement for equity investments. Hedge funds have typically been used to replace bonds. A new study has looked at the allocations of US pension funds since 2006 with a focus on the influence of investment consultants.

A key result of the study is to show how influential investment consulting firms are. None of the major economic indicators of a pension fund such as funding ratio or size and resources of the fund were able to explain more than 1% in the variation of the asset allocation between funds. But once investment consultants were included, the variation in asset allocation that could be explained jumped to 25%. Investment consultants have an outsized influence on pension fund allocation.

Another result is that the share of alternative assets has increased steadily in pension fund portfolios since 2006. Alternatives here contain private equity, real estate, and hedge funds. The increase in alternatives has been financed by reducing both equities and fixed income. In my experience, an increase in private equity and real estate is typically financed by reducing equity allocations, while an increase in hedge funds is financed by reducing fixed income. Hedge funds are typically perceived as the low- to mid-risk component of an alternatives portfolio.

Share of main categories in US pension fund portfolios

Source: Begenau et al. (2022)

That means, that instead of comparing hedge funds to equities, we better compare hedge funds to fixed income.

…and this is where the comparison becomes even less flattering for hedge funds. The chart below shows the performance of different hedge fund strategies over the last 20 years as calculated by the HFRX index of investable hedge funds (as opposed to uninvestable benchmarks that contain hedge funds closed for new investments). It also shows the Bloomberg US Aggregate Bond Market Index that combines Treasuries with investment grade and high yield corporates. It’s a benchmark often used by pension funds for their fixed income investments.

Performance of hedge funds and US aggregate bond market

Source: Bloomberg

I can already hear hedge fund advocates complain that the last 20 years were two decades of declining interest rates, providing significant support to fixed income investments. But shouldn’t hedge funds be able to perform in any market environment? And if a trend last for several decades, shouldn’t hedge fund managers not be able to adapt to that trend and design strategies that exploit such long-term trends?

Over the last 20 years, the US aggregate bond market index has had an annual return of 3.7% compared to 1.9% for the average hedge fund, 2.0% for equity hedge strategies, 2.6% for event-driven strategies, and 1.6% for macro/CTA strategies. At the same time, the volatility of the different hedge fund strategies was 1.5x to 2x the volatility of the fixed income index. In other words, hedge funds underperformed fixed income by 1% to 2% per year while exposing investors to higher volatility.

Over the last ten years, equity hedge strategies and event-driven strategies could at least match the performance of the fixed income market, but the volatility of these hedge funds was still twice as high as the volatility of fixed income portfolios.

Which begs the question, what exactly is the benefit of hedge funds in a portfolio if they cannot keep up with either stocks or bonds? Clearly, individual hedge funds have done extremely well for their clients, but as a group, hedge funds have disappointed on all fronts. The trick to good hedge fund performance is good manager selection, but if you think investment consultants can provide that for you, I have more bad news for you. This study looked at the recommendations of investment consultants in the equity space and found that equity funds recommended by investment consultants on average underperformed funds not recommended by consultants by 1.0% per year. I doubt the recommendations of investment consultants are any better in the hedge fund space.