Evaluating Hedge Funds Through a Different Lens

Hedge Fund Performance Attribution

For any investment, the total return can be broken into three components:

1. cash
2. beta
3. alpha

Let’s consider each through the lens of a hedge fund.

Cash: Perhaps because we went over a decade in an environment with rates near zero percent, it was easy to forget how important a contributor cash can be to the return for hedge funds. Cash returns contribute to performance in two main ways:

Short Rebate: when shorting a security, investors are required to hold cash collateral in their brokerage account. This collateral is often invested in cash-like securities and earn interest. A portion of this interest is then passed along to the short seller in the form of a short rebate.

Unencumbered Cash: at any given time, investment managers will maintain a cash balance that is typically low single digits; however, hedge funds that invest in derivatives markets tend to keep higher levels of cash on hand given the high use of margin with derivatives. This balance is held in cash-like securities and earns interest.

Everyone knows the story, that from 2009 through 2022, short-term interest rates were near zero, excepting a brief stretch from 2016 to 2020 when they reached a peak of 2.5%. Often forgotten, is how “high” rates were prior to 2008, notably investors survived much of the 1990s with rates above 5%.

One of my favorite stories on hedge fund return attribution is related to the cash return component. I was conducting due diligence on an equity hedge fund manager, and they provided performance attribution on a per year basis broken into three categories: “Longs”, “Shorts”, and “Other”.  The footnote for “Other” indicated this included “management fees, expenses, and other items.”  Unsurprisingly, this “Other” category contributed negatively to fund performance in every year except one, in the early 2000s. I asked the manager what happened that year, did they cancel all management fees that year and instead pay LPs to invest in their fund? As it turned out, the hedge fund manager had a rather substantial short book that year, and the short rebate earned during that time more than offset the management fees and expenses incurred throughout the year.  Amazing! Can you even imagine? (Also note the hedge fund manager didn’t keep the short rebate for themself – how admirable.)

That story helps explain why, when I started, the common benchmark for absolute return strategies was T-bills + 5%. It was understood (and expected) that as a base, these strategies should generate a cash return, simply due to the structure/mechanics of hedge fund investing.  Furthermore, early in the hedge fund industry, it was more common to see incentive fees accompanied by hard hurdle rates equal to cash. A clear recognition by the manager that they earn a cash return as a baseline and should not receive an incentive fee on cash interest.

Today, far fewer hedge fund managers have retained this compensation structure in their legal documents.  For more than a decade, the lack of a cash hurdle was immaterial, and this omission easily went unnoticed. However, with cash rates nearing 5%, this omission can be quite costly. Applying a 20% incentive fee when capturing a full 5% cash rate results in net returns 1% lower. If we expect hedge funds to generate mid-to-high single digit net performance, this 100 bps fee drag represents a material reduction in absolute returns.

I would not expect higher interest rates to cause hedge fund managers to become introspective and proactively (re)introduce cash hurdles into their incentive fee structures. Instead, it will be incumbent upon LPs to push back and require the inclusion of a hard hurdle. Certainly, some GPs will call the LPs bluff, but with 9,000+ hedge funds to invest in, perhaps LPs should focus their attention on those committed to abiding by the “Partner” in General Partner.

Beta: By definition, absolute return strategies should exhibit little to no beta to equity and/or fixed income markets.  In practice, this tends to play out, albeit with some strategies still maintaining modest beta (i.e., 0.2).  Irrespective, LPs should not seek or expect meaningful beta capture in these strategies. (Side note: LPs should be vigilant in uncovering “hidden” beta in absolute return strategies and take due action.) Given that, what’s the point of discussing beta and hedge funds?  Because beta (or the lack thereof), plays a significant role when analyzing relative returns.

When beta markets exhibit modest returns (as was the case from 1997 to 2008), having a (near) zero beta isn’t a major hinderance.  However, when equity markets, for example, go through a period of robust returns like we experienced from 2009 – 2022, the lack of beta is a major relative headwind.  During this 11-year period, absolute return strategies effectively generated 0% from their cash return and 0% from beta. All while equity beta compounded at 13% per year. That placed all the performance weight for hedge funds on the shoulders of alpha. Good luck finding 13% annualized (net of fees) alpha in just about any market. Hedge funds were doomed to exhibit poor relative performance over that time period. From 1997 to 2008, even in the absence of alpha, hedge funds would have looked relatively decent, given a positive cash return and weak performance in beta markets.

Alpha: Historically, this is why LPs were willing to pay hedge funds a 20% incentive fee…for an uncorrelated return stream produced via skill and expertise that cannot be replicated in other fund structures or traditional investments.  In absolute return strategies, how do hedge funds apply this unique expertise in their portfolio?  While there are several manifestations, identifying (mis)valuation spreads between two or more securities is a commonly understood trade. This could be via M&A arbitrage, convertible arbitrage, a variety of other arbitrage strategies, carry trades as seen in macro funds, or simply in a market neutral long/short equity fund via pair trades. An entire category of hedge funds (relative value) is dedicated to earning a return on spread conversion.

These spreads exist due, in part, to market inefficiencies. There is no question, over the last two decades markets have become increasingly efficient, whether through the growth of technology, the increase in the number of hedge fund managers, or the changes in market regulations, among other tailwinds. It is hard to argue that markets are as inefficient today as they were back when Ken Griffin (founder of Citadel) was trading convertible bonds in his dorm room in 1989. As such, I would argue that T-bills + 5% is no longer realistic for an absolute return hedge fund benchmark, simply recognizing increased efficiency in markets.

However, irrespective of market (in)efficiency, spreads also widen and narrow over time simply due to regular market movements, driven in part by volatility. Related to volatility is the concept of dispersion, or the degree of variation in the returns of securities (which contributes to valuation spreads). Research shows a strong correlation between alpha and dispersion[i] and a strong link between volatility and dispersion.[ii] Greater volatility and dispersion in the market is likely to lead to wider spreads and a larger opportunity set for relative value hedge fund strategies.

You may not be surprised to see this, but volatility (Exhibit 4) and dispersion (Exhibit 5) were more favorable pre-2008 than post 2008.

Volatility and dispersion ticked up in 2022, before declining again in 2023, and as it turns out, 2022 was one of the best years for hedge funds on a relative basis, while 2023 is shaping up to be a ho-hum year.

Bringing it all together