Declarations on real worth of hedge funds all over the map

How well hedge fund returns have met asset owners' expectations depends on to whom you're talking — or which report you're reading.

Research studies about whether hedge funds are still worth investing in have popped up like mushrooms since the beginning of the year when it became clear that 2015 hedge fund returns were below investors' expectations.

The problem for asset owners is that none of the studies from firms such as Mercer Investment Consulting, Cambridge Associates LLC, Markov Processes International Inc. and Agecroft Partners LLC, among others, reaches the same conclusions.

“All these studies about hedge funds are trying to get investors to set better expectations,” said Philip Zecher, chief investment officer of the $2.3 billion endowment of Michigan State University, East Lansing.

One recently released study — “Hedge Fund Reality Check,” by CEM Benchmarking Inc., Toronto — rattled institutional investors with its negative conclusions about the value-added characteristics of hedge funds, sources said.

Analysis of the hedge fund portfolio returns of a universe of more than 350 worldwide institutional investors over a 15-year period found that most of these portfolios did not deliver the benefits investors expected, said Alexander D. Beath, senior research analyst at CEM, who co-authored the hedge fund report with Michael Heale, principal.

The average net value added by hedge funds was -1.88% over the 15 years ended Dec. 31, compared with a customized CEM equity/debt index, Mr. Beath said, but pointed out that about 30% of the hedge fund portfolios in CEM's client database did outperform their customized CEM benchmarks.

“High costs are the main reason why hedge funds performed poorly,” Messrs. Beath and Heale wrote, noting in the report that in aggregate, hedge funds added a gross 0.97% of value over the CEM benchmarks for the 15-year span ended Dec. 31.

CEM analysis showed that average investment cost (management and performance fees) was 2.31% for portfolios of direct investments in hedge funds, which resulted in net added value of -1.66%, while the average hedge fund-of-funds fee was 3.56% (including underlying hedge fund manager fees and the hedge fund-of-funds fee) with net added value of -2.17%.

Clients of Cliffwater LLC, Marina del Re, Calif., asked so many questions about the CEM study that the specialist hedge fund consultant examined the study and issued a critique, said Stephen L. Nesbitt, Cliffwater's CEO.

“I'm not an apologist for hedge fund performance, but the methodology CEM used was so convoluted and flawed” that Cliffwater undertook a recalculation of the data, Mr. Nesbitt said.

Cliffwater researchers found three problems with CEM's methodology, according to their critique for clients:

nthe benchmark regression process includes a 100% allocation to stocks and bonds, excluding cash. Hedge funds tend to have low equity weightings, which forces the estimate benchmark to include “an outsized allocation to bonds.” Cash then is added to the benchmark to achieve the risk level equal to that of a hedge fund;

nthe study limits asset weights in the estimate benchmarks to 100%, “something that is a mistake in assessing hedge funds where the use of shorting and leverage can take asset exposures below 0% or over 100%;” and

nthe use of annual returns “makes their 15-year study the statistical equivalent (of ) 15 months.”

Cliffwater consultants said the three methodology errors mean that the -1.88% of underperformance CEM reported is inaccurate and after correcting the errors, found that hedge funds produced positive outperformance of 2.8% for the same 15-year period.

CEM created customized benchmarks because both “cash-based indexes and specialty hedge fund indexes ... suffer flaws,” the report said, noting that while “specialty hedge fund indexes had a reasonable correlation of 71% to hedge funds, simple equity/debt blends make superior, easy-to-understand hedge fund benchmarks.”

The report also criticized commercial indexes for not being investible and being easy to top in terms of performance

Kenneth J. Heinz, president of Hedge Fund Research Inc., Chicago, producer of the industry's most commonly used hedge fund indexes, said, “I think the (CEM) study is interesting, but I don't see anything in it that we haven't already thought of and done,” noting that the HFRL index family, launched a year ago offers investors a liquid, investible, intraday-priced subset of the firm's daily valued HFRX indexes.

Investment consultant Cambridge Associates LLC, Boston, presented real-life composite returns from the hedge fund portfolios of 347 of its advisory-only institutional investor clients in a report released earlier this month, “Hedge Fund-ing the Pension Deficit.”

“The only data set in the report is our clients' performance,” said Joseph Marenda, a Cambridge managing director and hedge fund specialist, stressing that “the dilemma for investors in comparing their hedge fund performance to others is which universe to use.”

On an annualized basis, the Cambridge Hedge Fund Advisory Composite outperformed the HFRI Fund of Funds Composite (Diversified) by 253 basis points and the Beta-Adjusted MSCI All Country World index by 247 basis points over the 10 years ended Dec. 31. Over 15 years, the Cambridge composite produced 222 basis points over the return of the HFRI index and 324 basis points over the MSCI ACWI index.

“Portfolio construction and manager selection are absolutely critical to hedge fund investment success,” said Mr. Marenda, noting that Cambridge researchers believe that just 5% of the 11,000 hedge funds active today are appropriate for institutional investment.

While Michigan State's Mr. Zecher said the CEM report is “high on conclusions and low on details, the results of the analysis doesn't surprise me. It's a gut reaction, but I think the finds are more true than not.

“Twenty years ago, when you invested in hedge funds, you did it to make money. But over time, as more investors got into hedge funds and more hedge funds sprung up, performance became less of the motivation to invest,” Mr. Zecher said.

“Investors have to do what they should have done in the beginning — set the right expectations. Investors get into hedge funds now because they expect them to control volatility and risk in their portfolios and at the same time, expect high returns. But those three factors are not correlated with each other. You have to choose and match your expectations to that choice,” Mr. Zecher said. n