Op-Ed: Using the Risk-Free Rate as a Basis to Examine Hedge Fund Costs

The first and second parts of this article explained how and why it is helpful for allocators to directly connect investment costs and the risk-free return (yield on the 91-day Treasury Bill). Part Three explains how allocators can use this same framework to examine the cost of specific products, such as hedge funds. 

Ultimately, the approach I am encouraging allocators to consider is intended to help quantify the changing impact of fees as the risk-free return moves up and down. By understanding this dynamic, allocators can optimize the use of their program budget and hopefully make wise choices with respect to hiring active managers, especially high fee managers, such as hedge funds. 

To explain, we will once again refer to the expected return equation, which is:  

Expected return = the risk-free rate + the risk premium + alpha. 

Since the risk-free return is the starting point upon which the expected return forecast is formed, the level of the risk-free return matters significantly (especially to investors of high fee offerings, as you will see below). A key point of this article focuses on the fact that the average annualized return of the risk-free rate (the 91-day Treasury Bill) averaged 3.2% for the decade prior to the Great Recession (10-year period ending Dec. 31, 2008) and 0.5% since (from Jan. 1, 2009, to June 30, 2020). As you will see below, this difference in starting point has significant implications to hedge fund investors, especially on an after-fee basis. 

As done in the first and second parts of this article, this section will demonstrate how manager fees can be netted against the risk-free rate to form the starting point of an expected return forecast.

This section of the article does not intend to justify recent hedge fund performance; however, it does reveal that hedge fund managers have actually delivered about the same “gross” excess return above the risk-free rate since the Great Recession as they did prior. But hedge fund investors since the Great Recession experienced much lower absolute returns, largely because these investors were required to pay high fees in a low risk-free rate environment. 

Hedge Fund Returns Decomposed

To explain this further, let’s look at hedge fund returns before and after the Great Recession. We are all aware of the shortcomings of many hedge fund benchmarks, but I am using the returns of two common hedge fund indices, the HFRX Global and the HFRI Fund-of-Funds Composite, for this illustration. 

As the table below illustrates, the HFRX Global Index returned 5.6% for the 10-year period ending Dec. 31, 2008, while the HFRI FoF Composite had a 5.3% return during this same time period. Both indices meaningfully outperformed the 1.7% return of the passive 60/40 portfolio.

Hedge Fund Returns 

Source: Marquette Associates

However, the average annualized returns of the two hedge fund indices have decreased meaningfully since the Great Recession. The HFRX Global index averaged annualized returns decreased from 5.6% to 2% and the HFRI FoF Composite average annualized returns decreased from 5.3% to 3.2%. Both indices woefully underperformed the 10.1% average annualized returns of the passive 60/40 portfolio.  

In addition to the meaningful decline in absolute and relative performance of the hedge fund indices since the Great Recession, one other important detail should be noted—the average annualized return of the 91-day T-Bill dropped 270 basis points (bps) from 3.2% to 0.5% across these two time periods. The decline in the risk-free rate is significant and can explain a large portion of the drop in the average annualized returns of hedge funds since the Great Recession. 

To illustrate this point, we can refer back to the expected return equation and apply to it to the hedge fund indices as: 

Hedge fund index return = the risk-free rate + the risk premium + alpha.

For this illustration:

• The risk-free rate = 91-day T-Bill;
• The risk premium = 0%; and
• Alpha = the net excess return above the risk-free rate.

Recall from the first and second parts of this article that the risk premium is simply the return of a passive index minus the risk-free rate. In the prior articles, the returns of the passive 60/40 portfolio minus the risk-free rate were used as the risk premium. An investor can choose whatever index is most appropriate for the product under consideration and use that index’s corresponding returns minus the risk-free rate as the risk premium (so this process can be applied to any product or manager).   

For hedge funds, a 0% risk premium is appropriate. Many allocators invest in hedge funds that seek to provide uncorrelated returns to traditional equity and credit markets (and many general partners [GPs] sell their products as vehicles that will achieve this objective). And many institutional investment policies set a “CPI + x%” return objective for hedge funds (low volatility is also a common policy objective). So, examining costs through the lens of the risk-free rate + the excess return aligns with institutional investor portfolio and policy objectives. Of course, a “zero” correlation to traditional equity and credit factors is nearly impossible to achieve, but we will make this assumption in keeping with the spirit of how hedge funds are often used by institutional investors and how policies are written. This assumption also means that any returns by the hedge funds above the risk-free rate are deemed to be alpha. 

Using these assumptions and looking at the 10-year period ending Dec. 31, 2008, we observe HFRX Global Index returned 5.6% and the risk-free rate during this same time period was 3.2%. This means the managers in the index produced 2.4% in excess returns above the risk-free return (or 5.6% minus the risk-free rate of 3.2%). Similarly, the HFRI FoF Composite returned 5.3% during this time period, meaning that the composite constituents achieved excess returns above the risk-free rate of 2.1% (or 5.3% minus the risk-free of 3.2%).   

Excess Returns Above the Risk-Free Return

10 Year Period Ending 12/31/08

Since 1/1/09

*Net alpha = after fee return above the risk-free return

As the data above shows, hedge fund returns since the Great Recession have been much lower. The average annualized return for the HFRX Global Index dropped from 5.6% before the Great Recession to 2% since, and the HFRI FoF Composite dropped from 5.3% before the Great Recession to 3.2% since. However, the risk-free return also dropped during this time, from 3.2% to 0.5%. Therefore, since the Great Recession, the “net” alpha for managers in the HFRX Global Index was 1.5% (2% minus the risk-free rate of 0.5%) and “net” alpha for the HFRI FoF Composite constituents was 2.7% (3.2% minus the risk-free rate of 0.5%).

Immediately, allocators can see that hedge fund excess returns above the risk-free rate remained relatively consistent for the periods before and after the Great Recession (ranging from 90 bps for the HFRX Global Index and 60 bps for the HFRI FoF Composite).  

If hedge fund excess returns above the risk-free rate were similar before and after the Great Recession, what caused the significant decline in hedge fund absolute returns since the Great Recession? The decline in the absolute returns between the two time periods can be at least partially attributed to the 270 basis point decline in the risk-free rate. 

Importantly, the 270 basis point drop in the risk-free rate also means that hedge fund investors since the Great Recession had to give up a higher percentage of the “free” return to pursue alpha.

Paying the same fees while the “free” return is declining can create a meaningful obstacle for investors, as explained by Marquette Associates consultant Dave Smith, who notes that, “There are no shortage of explanations for the low hedge fund returns and their dramatic underperformance relative to the passive 60/40 portfolio since the Great Financial Crisis. Over capacity, the declining number of public stocks, low volatility, Reg D, distortions in price discovery stemming from central bank intervention, crowding, and the concentration of market leadership in just a few mega-cap stocks have all been cited as challenges to hedge fund absolute and relative returns. But we also believe that product fees against a backdrop of compressing risk-free returns has presented a major and often unaccounted for headwind to hedge fund net returns.”

Netting Management Fees Against the Risk-Free Rate

In the first and second parts of this article, I encouraged allocators to evaluate investment costs by directly connecting fees and expenses to the risk-free return. We can apply that same approach to examine the impact of hedge fund fees, as explained below. 

Very few hedge fund investors still invest at a 2%/20% fee structure, but that fee structure was common prior to the Great Recession. To keep it simple, we will use that fee structure in the examples below. Using the 2%/20% fee assumption and the methodology to net management fees against the risk-free rate, we can make some interesting conclusions regarding the importance of cost controls in a low rate environment.  

Recall that for the 10-year period ending Dec. 31, 2008, the average annualized return of the risk-free rate was 3.2%. Using the 2% fee assumption and applying the methodology to net fees against the risk-free rate, we can see that pre-Great Recession hedge fund investors still retained 1.2% of the available 3.2% “free” return even after paying the 2% management fee (3.2% – 2%). 

As shown below, this means that the GPs in the HFRX Global Index delivered 4.4% in excess returns above the “net of fee risk-free return.” Similarly, for the HFRI FoF Composite, the collective group of hedge fund managers in this index generated 4.1% in excess returns above the “net of fee risk-free return.” 

Fees vs. RF Rate Framework

10 Year period Ending 12/31/08

*Alpha = excess net return above the after management fee risk-free return

Mostly because of Fed intervention, the “free” return available in the market has been driven down from 3.2% for the 10-year period prior to the Great Recession to 0.5% since. Therefore, since Jan. 1, 2009, a 2% management fee required the hedge fund investor to give up the 0.5% risk-free return AND also accept a 1.5% deficit relative the “free” return. 

As shown below, the HFRX Global Index returned a net average annualized return of 2% since the Great Recession, meaning that GPs in the index generated alpha of 3.5% to make up the 150 bps “free” return deficit and deliver the 2% net return. The average annualized return for the HFRI FoF Composite since the Great Recession was 3.2%, meaning that the managers in that index generated 4.7% in net of manager fee alpha during this time period. 

Fees vs. RF Rate Framework

Since 1/1/09

*Alpha = excess net return above the after management fee risk-free return

In decomposing the hedge fund returns in this way, we can observe that hedge fund excess returns above the after-fee risk-free return remained steady before and after the Great Recession. In fact, if we viewed the excess return as the percentage return above the risk-free rate (return premium), one could argue that hedge fund managers have actually been better since the Great Recession (since they have delivered a higher multiple above the risk-free return after the Great Recession than before). For example, the 5.6% pre-Great Recession net return for the HFRX Global index is 1.6x the 3.2% return of the risk-free rate during that period, while the 2% Post-GFC net return for the index is 4x the 0.5% risk-free return for that period. In your opinion, during which period of time did the managers perform better?

Despite the ability of hedge fund managers to consistently deliver excess returns above the risk-free return before and after the Great Recession, the “net” returns to investors since the Great Recession have been much lower. The post-Great Recession returns have been compromised because manager fees required the investor to give up a much higher percentage of the “free” return. Consider that the fees paid by the pre-Great Recession hedge fund investor required the investor to give-up two-thirds of the “free” return (but at least they kept a third of the free return). Whereas, those same fees for the post-Great Recession hedge fund investor required the investor to give up four times the risk-free rate (and put the investor in a 150 bps deficit relative to the risk-free rate)! The difference between keeping one-third of the “free” return and giving up four times the “free” return is significant, and, in my opinion, accounts for most of the difference in net realized returns of hedge funds before and after the Great Recession.

Suggested Approach versus Others

Obviously, the methodology I am suggesting does not change a hedge fund investor’s realized return, so an allocator may be asking, “Why not just underwrite a manager’s expected return by netting the 2%/20% fee from the gross return expectations?” Using that method is perfectly fine (and the most common); however, examining the after-fee “alpha” potential (or netting the 2%/20% from gross alpha expectations) only focuses on one of the two factors driving hedge fund absolute returns. Remember, hedge fund expected returns are a combination of the risk-free rate plus “net” alpha expectations (assuming a 0% risk premium). The traditional approach does not properly account for changes to the risk-free rate. Notice in the illustrations above that hedge fund “net alpha” was similar before and after the Great Recession. An investor only focused on “net alpha” expectations may have falsely assumed that since hedge fund “net alpha” was the same before and after the Great Recession, hedge fund absolute returns would have been the same before and after the Great Recession (which we know was not the case).  

Since the risk-free rate is the starting point for developing an expected return forecast, it is helpful to be mindful of that starting point and also to quantify your position relative to that starting point. This can be done by netting fees against the risk-free rate. The difference between starting with +1.2% “after fee risk-free return” (as hedge fund investors did before the Great Recession) versus a -1.5% deficit to the “after fee risk-free return” (as hedge fund investors have since) is material! And, yet, potentially not detected or factored in by the more traditional manager underwriting process, meaning forecast absolute returns may not be accurate even if the “net” alpha forecasts are accurate.    

Other Considerations

It would be important to note the fact that the risk premium of the passive 60/40 portfolio increased massively after the Great Recession (likely because of the significant Fed stimulus). In viewing the return chart at the top of this article, we can see that for the 10-year period ending Dec. 31, 2008, a passive 60/40 investor actually experienced a -1.5% risk premium (1.7% return minus the 3.2% risk-free return). For this 10-year period, an investor would have been better off investing in the 91-day T-Bill rather than in the 60/40 portfolio. However, the -1.5% risk premium prior to the Great Recession turned into a remarkable, and significantly above average, +9.6% risk premium from Jan. 1, 2009, to June 30, 2020, (10.1% minus 0.5% risk-free return)!   

Hedge fund returns did not mirror the results of the passive 60/40 portfolio during these two periods. Specifically, hedge fund returns were not as low as the 60/40 portfolio for the 10-year period before the Great Recession and not as high as the passive 60/40 portfolio since the Great Recession. As we noted above, most institutional allocators invest in hedge funds that seek to provide uncorrelated returns to traditional equity and credit factors. Therefore, the uncorrelated outcomes make sense. And are even desirable given the return and policy objectives often assigned to hedge funds.

While hedge fund managers have been criticized for woeful absolute and relative performance versus the passive 60/40 portfolio since the Great Recession, I believe part of this criticism is undeserved as it likely stems from the false expectation that the hedge fund managers should have captured the 9.6% risk premium available to the passive 60/40 investors since the Great Recession. But remember, they were not supposed to!

And based on the examination above, it appears that hedge fund managers skillfully delivered about the same “gross” excess returns above the risk-free return prior to and since Great Recession. So, in my opinion, hedge fund expertise does exist, but the question for allocators is “how much of the risk-free return are we willing to give up to partner with that expertise”?  When the risk-free rate is 0.5% and we must hand that “free” return plus an additional 150 bps to the manager, we might want to think twice before committing our capital. Or, at least, only do so if we have high conviction that the manager can both overcome the 150 bps “free” return deficit (which requires the manager to deliver a return three times the risk-free rate) and also deliver returns that meet the required absolute return targets. Without a massive increase in risk or leverage, this is not an easy task, at least in my opinion.  

Notice, too, that I have not accounted for the 20%“carry” in this illustration. Factoring in the “carry” does not change the conclusion of this article and, in fact, its inclusion would more firmly reinforce the point that controlling fees in a low rate environment is essential. 

Also keep in mind that the framework I am suggesting is especially relevant today with the yield of the 91-day T-Bill hovering just below 15 bps. An investor paying a 2% management fee to a manager is giving up all of the “free” return plus assuming a 185 bps deficit relative to the “free” return! A manager must produce returns more than 12x the risk-free rate (15 bps x 12 = 180 bps) just to get close to even with the “free” return. And, since an investor still requires some rate of return above the risk-free rate to meet policy and other investment objectives, the hedge fund manager must generate extremely high returns to warrant inclusion in the portfolio.

And remember too that this framework does not only apply to manager fees, but also to “program” fees. For example, an institution paying an outsourced provider more than 15 bps today is giving the 15 bps “free” return to the outsourced chief investment officer (OCIO). A 50 bps fee for an OCIO (as an example only) means that the institution is starting with a 35 bps deficit to the “free” return before products and managers are even hired. The OCIO and the managers in these programs will have to generate significant returns above the risk-free rate to offset these fees and generate high enough returns to meet the financial objectives of the organization. 

Conclusion

We all know that active management and the pursuit of alpha is expensive. But it is important to note that the pursuit of alpha gets more expensive as the “free” return declines. By associating investment costs to the “free” return, we can more clearly quantify the changing impact of costs, which will help us make better choices when hiring active managers.

In times like these, our institutions are working hard to optimize the cost structure for the organization. We owe it to our institution and its mission to follow suit in our investment programs. I hope you agree that being able to answer the question “how much of the ‘free’ return am I willing to give up to hire this manager?” gives you a better framework to achieve this important objective.  

Tony Waskiewicz has nearly 30 years of financial services, investment advisory, and CIO experience and most recently served as chief investment officer for Mercy Health in St. Louis.

This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of Institutional Shareholder Services or its affiliates.

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