To present our results, we started with the database from Hedgefund.net. The database consists of 3,561 funds with assets of $493 billion as of May 2004. After eliminating funds of funds, off-shore funds and clones, we were left with 1,262 U.S. hedge funds. This group represents 31 different hedge fund strategies, with the bulk of the assets in 12 categories. Hence, our starting point will consist of the top 12 strategies, which comprise 79% of the number of U.S. hedge funds and more than 88% of the assets (Figure 1).
Drilling down within this subset of managers leads to interesting results about the differences in performance among hedge fund strategies.
Figure 2 highlights the mean return and volatility3 of performance for different hedge fund strategies.
Figure 3 shows the dispersion of returns for the 39 quarters from September 1994 through March 2004 for long/short equity funds. To establish a baseline for comparison, we illustrate the range of results in a universe of long-only, large-cap value managers. It is apparent that the difference of returns for the same strategy in just one quarter can be very large-more than 180 percentage points for the long/short funds, contrasted with 30 percentage points for large-cap value managers5. Additionally, it is noteworthy that the differences are increasing over time, as illustrated in the trend line in the chart.
Figure 4 shows the monthly maximum and average difference of all the major strategies since 1990 or when the data for the strategy started, whichever is later. It can be seen that for the 12 major strategies the maximum differences have been large, and for eight of the 12, on average, the difference has been greater than ten percentage points. And the performance gap is increasing across all strategies as more funds open. Obviously, there is a huge incentive to select the "right" funds and avoid the "wrong" ones.
Why not just select the funds that have had the best performance over the last three or four years? Figure 5 is based upon the 269 U.S. hedge funds that have monthly returns from August 1996 through July 20046. The table shows two periods of subsequent performance for those funds that were the 68 best and 68 worst performers for the 48 months prior to July 31, 2000. In the first period, only 15 of the best performers continued to be top performs for the next year; 40, or 58%, dropped to the bottom half, with 30 of those in the bottom quartile. On the other hand, 23 of the bottom 68 performers were among the best performers one year later. Only 14 remained among the bottom performers. Thus, past performance is not much help in finding future top performers. Even over a longer time period of four years, the results are similar. One difference is that only six funds (8%) stayed among the worst performers.
After-tax return is another important aspect in evaluating hedge fund returns. While a precise measure is probably not possible, some reasonable estimates can be made. In order to estimate the after-tax returns, a number of factors should be considered: (l) an estimate of what portion of the return will be classified as current income; (2) when the tax must be paid on long-term gains; (3) portfolio turnover; and (4) the use of derivatives. The latter will have a significant impact on the categorization of returns for tax purposes.
Funds with high turnover may make a Section 475 election, which means they mark the portfolio to market at the end of each year and all gains and losses for the year, whether realized or not, are classified as current income. Funds that use futures contracts are affected by Section 1256 of the tax code. Section 1256 contracts, which include regulated futures and foreign currency contracts, must be marked to market at year end, and associated gains and losses are treated as capital gains and losses, with 60% characterized as long-term capital gains or losses and 40% characterized as short-term capital gains and losses. Finally, some funds make extensive use of trading strategies and redemptions in kind to significantly reduce current taxation on the fund. The investor must insure that a full description of the strategy, turnover, use of derivatives, etc., is provided to the investor's tax advisor so that the advisor can determine the tax impacts of the funds under consideration. This will permit the advisor to help select the funds that are most appropriate for the individual investor's needs and tax situation. While tax leakage is an important consideration in wealth accumulation, selection of a bad fund for good tax reasons will lead to a loss of wealth.
Fees Disclosure
Hedge funds are typically more expensive than traditional mutual funds. Because these are not mutual funds, hedge funds can charge performance fees as opposed to a straight expense ratio. Some of the expenses of a hedge fund are obvious, but some are embedded into the funds. Here is what to look for: