Disappointment is all relative

In general, investors feel disappointed by the recent performance of hedge funds. The level of disappointment is a function of the distance between facts and expectations. In the case of hedge funds, both variables are misunderstood and biased.

The facts, or the risk/reward of hedge funds in our case, measured by returns and volatility, are not easily observable. Several indices, like the Dow Jones Credit Suisse index series, try to capture the overall hedge funds' characteristics. They differ in their construction methodologies, components and are distorted by well known biases like the survirvorship bias. Therefore, results can differ significantly from one to the other. The return YTD at the end of November was 6.10% and 2.57% according to the Dow Jones Broad Hedge Fund Index and the HFRX Global Hedge Fund Index respectively. A significant 3.5% difference. Even if we assume that anyone of them provide a good representation of the hedge fund investment universe, none of them is investable, compared to equity indices which are accessible to investors through many instruments (ETF, futures, mutual funds ...). In fact, each investor have only a subset of the 7'867 single manager hedge funds reporting at the end of November 2012. Therefore, investors' individual performance will likely diverge particularly since performance dispersion has been high recently. For the 12-month period ended Sept. 30, the top 10 percent of funds reported an average gain of 34 percent, while the bottom 10 percent saw an average 19 percent loss, according to Hedge Fund Research Inc. of Chicago.


As we have seen, the benchmark that actual or potential investors shall use to measure their disappointment is to say the least blur. The problem become even more acute when we look at investors' expectations from hedge funds.
There is two way to define risk/reward expectations, absolute or relative. The absolute expectation will take the form of a minimum threshold. The investor can be simply looking for an absolute return (not loosing money in any market environment) or for an annualized return of X%. The relative expectation will look for overperforming a benchmark for example +2% over an equity index on an annual basis. The volatility, or another measure of risk, can also be used to define expectations. An important feature of hedge funds has been their low correlation to other asset classes. If an investors's expectations from his hedge fund investment is diversification, he will likely emphasis correlation measures.

Another significant parameter in defining expectations is the time frame. Over which period will we be measuring the facts against your expectations.

Let's take the example of an investors looking for relative overperformance of hedge funds, represented by the Dow Jones Credit Suisse Core index, compared to the equity market.

If we look at 5 years returns, hedge funds, represented by the yellow line, have outperformed equities, represented by the green line , for almost all the period since 2001. The results are almost the same if we look at 3 years time windows except since September 2011 when equities started to outperform. As usual, investors tend to emphasis recent history and to forget that over the past 18 years hedge funds have been ahead most of the time.

In the case of an investors looking for an absolute return investment, we see from the graph that hedge funds never had a 5 years period with a negative return and only one 3  year negative window for the period ending in April 2009.

As we have seen disappointment is all very relative and even if recent returns from hedge funds have marked low investors should review their motivations in investing with hedge fund managers and clearly define their benchmarks and expectations.