The Case Against Hedge Fund Managers | Chief Investment Officer

Most funds are actually passive—not unlike alternative beta strategies—and even fail to deliver superior performance over the long term, according to recent research.

Hedge fund managers are failing to do what they are meant to do: generate outperformance through active management.

According to a paper written by Mikhail Tupitsyn and Paul Lajbcygier of Australia’s Monash University, most hedge funds are actually passive and not too different from alternative beta strategies.

“While in the short term hedge funds may engage in dynamic trading strategies involving complex securities, over the long run many of them behave like alternative beta portfolios.”Specifically, only one-fifth of more than 5,500 hedge funds from 1994 to 2010 had nonlinear exposures to risk factors that drive hedge funds returns, the study found.

An overwhelming two-thirds of the funds exhibited only linear risk exposures—or were passive.

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“These results mean that while in the short term hedge funds may engage in dynamic trading strategies involving complex securities, over the long run many of them behave like alternative beta portfolios,” the authors wrote.

Of the different styles of hedge funds, arbitrage, event-driven strategies, and managed futures were the most likely to have nonlinear risk exposures, according to the study.

On the other hand, directional styles—long-short equity, dedicated short bias, and emerging market funds—were mostly passive.

Furthermore, the study found nonlinear funds on average underperformed their not-so-active counterparts.

From 1995 to 2009, the study found nonlinear funds’ returns were 0.1% lower than those of linear funds. They performed even more poorly compared to market-neutral funds, falling 0.28% lower while featuring higher volatility.

These more active hedge funds also had higher negative tail risk and lower Sharpe ratio and alpha than linear funds, the authors added.

In addition, only 15% to 25% of hedge funds and managers that exhibited true skill remained that way over the long term, the paper said, as they failed to withstand poor performance.

“After suffering poor performance compared to linear funds, some of the nonlinear funds do not survive and close down, while others alter their risk profile and become linear funds in order to remain competitive and attract assets under management,” Tupitsyn and Lajbcygier wrote.

Some 40% of nonlinear funds from 1994 to 1998 transitioned over to the passive side in the period between 1999 and 2003.

In comparison, the study found 70% to 85% of passive funds remained passive.

Read the full paper, “Passive Hedge Funds”.

Swedish government pension fund AP4 has launched a search for a manager specialising in environmentally-friendly water companies.

AP4’s chief executive Mats Andersson has been a vocal proponent of climate change-friendly investment and the fund has put its name to a series of global ventures aiming to reduce carbon output and take a more responsible approach to asset management.

“In the short term, it is chance that determines whether the sustainable investment is good or bad, but long term I am convinced that they will lead to higher returns.” —Mats Andersson, AP4In an announcement on its website, the $36.5 billion fund said sustainable investments were essential for a long-term strategy.

“AP4 is constantly working to manage risks and opportunities in management, including those related to sustainability,” the fund said. “That conviction is reflected in the governance structure, business philosophy, and strategies and our management works continuously to develop and invest in different strategies when they meet AP4’s criteria for sustainability and profitability.”

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The mandate is focused on companies seeking to address the global shortage of water, AP4 said. The active, long-only mandate is up for tender until August 20.

Andersson emphasised that the investment was not being made “out of charity”, but with confidence that it would achieve “better long-term returns for retirees”.

“In the short term, it is chance that determines whether the sustainable investment is good or bad, but long term I am convinced that they will lead to higher returns,” Andersson said.

AP4 already dedicates a significant proportion of its portfolio to environment-focused investments. In 2014 it invested roughly $350 million in green bonds, and is a founder member of the Portfolio Decarbonization Coalition, which aims to get $100 billion invested in carbon-reducing strategies by the end of this year.

Speaking to CIO last year, James Holley, senior manager at consultancy firm KPMG, said it was important for investors to embrace opportunities to make money from new technologies aiming to solve environmental problems.

“There are new technologies and services that are the products of innovation happening all over the world, and rather than policymakers, it is industry and investors who should be the driving force behind them,” he said.