Researchers have identified flaws in a commonly used measure of investment fund performance and say the new tool they have developed reveals hedge funds and many active management strategies are under-performing the market, often to a dramatic extent.
Low-cost index funds, rather than hedge funds or actively managed funds, are the smartest place to invest, the new measurement tool suggests.
“We found that hedge funds generate returns that, after adjusting for risk, are significantly lower than index funds. Many active management strategies also underperformed, often to a dramatic extent,” says finance researcher Dr John Crosby
from the University of Technology Sydney.
Index funds, such as those provided by Vanguard, BlackRock and State Street, track the stock market and charge fees between 0.07% and 0.5% per year. They have experienced massive growth in the last few years.
Hedge funds and other actively managed funds employ analysts to pick stocks and other securities to try to beat the market and provide investors with higher returns, but they also charge higher management fees, from 1% to 4% per year. Some funds also charge performance fees.
The standard industry measure to help investors decide which funds provide the best risk-adjusted return is the Sharpe ratio, but this has flaws, says Crosby.
“The Sharpe ratio doesn’t take into account issues such as opaque investment strategies and short performance histories, and it can be manipulated,” says Crosby, who previously worked as an investment banker at Barclays in London and UBS in Switzerland.
“Hedge funds in particular lack transparency – investors are not always privy to changes in strategy that increase risk, such as increasing leverage, or the use of exotic investment products such as collateralised debt obligations or credit default swaps.”
Long-Term Capital Management, a US hedge fund that was backed by Nobel Prize-winning economists, is an example of how things can go terribly wrong – it lost more than $4 billion of investor’s money in a couple of months due to high leverage strategies.
“Other hedge fund tricks include starting multiple funds and then only promoting those that achieve high returns in the short-term, to woo investors. This is why a reliable performance history matters,” Crosby says.
Crosby worked with fellow researchers, Dean’s Professor of Finance Gurdip Bakshi and Visiting Assistant Professor Xiaohui Gao Bakshi from the Robert H. Smith School of Business, University of Maryland, to develop a new measurement tool called MAP.
MAP takes into account these higher degrees of riskiness, to better assist investors evaluate fund performance.
A unique feature of the new measure is that it takes into account ambiguity aversion. This is the preference for risks with known probabilities over risks with unknown or vague probabilities.
“We found that there can be – and often was – a very low correlation between our new measure and the Sharpe ratio, so the two measures are distinct from an economic point of view,” Crosby says.
“Put differently, our new performance measure is capturing a different dimension of risk and reward.”
The researchers applied the new measure to a range of investments, including hedge fund indices, futures options, managed funds and index funds.
“The bottom line is, using our new measure, they all underperformed the market, or at most broke even. Interestingly, some had quite high Sharpe ratios.
“Investors are better off putting their money in low-cost index funds that simply track a broad-based equity index.
“These findings are surprising given the huge sums – trillions of dollars – invested in hedge funds and actively managed funds,” Crosby says.
One of the main reasons for the difference in performance was fees. Funds that charge high fees must perform significantly better just to match the index’s return.
“You don’t need to pay a hedge fund manager. You can take out of the loop the guy who wants to be paid $2 million a year,” Crosby says.
The research findings were presented at the Financial Research Network (FIRN) annual conference in Uluru last week.
Read the working paper here