This Is the End


Markets, Risk and Human Interaction

April 1, 2009

Measuring the value-added of hedge funds

The co-heads of Goldman’s Global Alpha hedge fund, Messrs. Carhart and Iwanowski, are calling it quits. A few years ago I was running a hedge fund at FrontPoint Partners and we were bought out by Morgan Stanley just in time to attend MSIM’s annual managing directors meeting. All they talked about at that meeting was what MSIM could do to be more like Goldman’s Global Alpha. It was a fierce machine, the gold standard. And it had some years of stellar returns. They rode their hedge fund up to a peak of $12 billion a couple of years ago. Since then they have seen it shrink to $2 billion.

If you are Carhart and Iwanowski, or for that matter AQR’s Asness or Citadel’s Griffin and have a really bad year, at least you can gain some solace by saying to yourself, “Things didn’t roll my way this year, but still, since inception I have on average delivered 15% returns.” Or putting the same sentiment differently, “Even though this has been a hard year, if you had invested $10,000 with me when I started, it would still be worth $300,00 today.”

Actually, no. If you use those benchmarks to define your career as a hedge fund manager, you are doing it wrong. Because hardly any of your investors did put their money with you way back when. In fact, most of them put their money with you over the past three or four years, years where returns moved from hum-drum to disastrous.

I have a hypothesis that would be easy to test with the right data: Some of the large hedge funds that have drawn down substantially in the past year or two have on net lost money for their investors since inception. This, even though they have collected huge fees and have decent average annual returns. The reason I think this might be the case is that in the current downturn they had a lot more money under management, and so had more dollars to lose per unit of poor performance, than when they were knocking the cover off the ball in their early years. Some of the hedge funds that are on the ropes grew larger and larger over time, reaching elephantine size just in time to implode. Some of these were starting to stumble under their own weight in the years before that.

A performance statistic to gauge the overall economic value-added for hedge funds is capital-weighted annualized returns. It would help to answer the question of a hedge fund’s – or the hedge fund industry’s – life-time economic value added; it would be useful even for large hedge funds that have not struggled the way that Global Alpha has. I don’t really care as much about what a $20 billion dollar fund did ten or fifteen years ago when it had $1 billion than how it did in the more recent years when it was trying to put these larger levels of capital to work.


  1. I don't know much about this fund other than what I read when it began imploding in 2007 and something stinks to high-heaven on this one. They were claiming to run like 15 or 20 uncorrelated alpha strategies within one fund --- kind of a fund of funds within a single fund. Well, how in the world could this fund have lost as much as it did given this as the strategy of the fund. Yes, correlations rise in times of stress --- but I learned that on my CFA exam 10 years ago (in an article entitled "Global Risk Management: Are We Missing The Point" by a fellow named Bookstaber, btw)

    Learning Outcome Statement 2.d:

    Appraise the usefulness of variance and correlation during market crises.

    'the benefits of diversification are reduced during market crises, which is exactly when you need the diversification the most.'

  2. It is an interesting idea, but how would you propose said measurement? As much as hedge funds like to claim to be beta-neutral strategies, as far as I can tell, they are just levered beta funds. In essence, with the market always changing, what is your counterpoint (benchmark) for comparison? What is "average" or "expected" gains or losses per $ AUM ?

  3. I am not thinking as far ahead as what a benchmark or a reasonable number would be for capital-weighted return. The first thing I would want to see is how often hedge funds have, at the end of the day, produced small or even negative value-added for their investors.

  4. Good news, Rick: The study you wanted came out a month ago. See Dichev-Yu below. Even with data ending in 2006, the results are bad, as you expected, and will get worse when 2008 data are included.

    Higher Risk, Lower Returns: What Hedge Fund Investors Really Earn
    This study makes a critical distinction between the returns of hedge funds and the returns of investors in these funds. Investor returns depend not only on the returns of the funds they hold but also on the timing and magnitude of their capital flows into and out of these funds. The capital flow effect exists for any investment but is especially relevant for hedge funds because of the large magnitude and variation in the associated capital flows. We use dollar-weighted returns (a form of IRR) to assess the properties of actual investor returns on hedge funds and compare them to buy-and-hold fund returns. Our first finding is that annualized dollar-weighted returns are on average about 4 percent lower than corresponding buy-and-hold fund returns. This performance gap rises to as much as 9 percent for "star" funds with the highest buy-and-hold returns and for funds with high volatility of capital flows, a remarkable difference in assessing long-run investment performance. In addition, dollar-weighted returns are below comparable returns for broad-based stock indexes. Our second finding is that dollar-weighted returns are more variable than their buy-and-hold counterparts. The combined impression from these results is that the return experience of hedge fund investors is much worse than previously thought.

  5. What's wrong with IRR for a capital weighted return?

  6. IRR of a capital-weighted return, the sort of thing being done in the paper cited in the comment above, is what I am getting at. It would be interesting to have the Dichev-Yu paper updated to the end of 2008, and have the methodology applied on a individual hedge fund basis. And just for fun, have the results juxtaposed with the total fees earned.

  7. answer this question rick....i have 5 Ken Griffey Jr. rookie cards that I think are pretty valuable....and then I meet someone who has 50 of them just in his pocket....and he tells me there are thousands more that will be printed very shortly....what should I do with my 5 Ken Griffey Jr. rookie cards?....

  8. Why is it more appropriate to use capital-weighted returns instead of excess return benchmarks? Isn't the important question for an investor how would an investment in this fund compared over time to various asset classes (putting aside the question of whether hedge funds are an asset class, per se).

  9. Volume Weighted Average Price (as in stocks) could be a good measure or return (against the last price)?

  10. Using such a metric would show that the majority of hedge funds lose money on an absolute basis (while still having a positive CAGR). However that is NOT the fund managers fault, but the investors fault for buying into a fund at or near the top and redeeming at the bottoms, just like the majority of investors are accustomed to doing. Can't blame the fund manager for that, sorry.

  11. No blame intended. They are trying to do their job as best they can. Although in some cases maybe they also consented to become too big. It is a metric that has no innate judgment attached. How someone views it is up to the individual.

  12. I worked at a fund of funds that invested mostly in managers with significant AUM (5B+). I can say for sure that after 2008 many household name funds have a negative return using this method given the massive AUM growth in 04-08. Note that I am not counting money that was redeemed along the way (this would be impossible data to get). That would have to be included to get a true economic benefit added under a cap weighted metric.

  13. listen rick....what your are talking about is irrelevant....the answer to the above question is that i try to sell my Ken Griffey Jr rookie cards when I find out that someone is about to print 1000 of them very shortly....i think that is what the world is doing with their u.s. dollars right now....

  14. I have always worked in the fully-funded, but never levered, world. My big discomfort with hedgie performance analysis is that it never, to my knowledge, uses a risk-neutral bench. The only really meaningful return comparisons are risk-neutral. Otherwise apples and oranges... Given that risk neutrality is a moving target, has anyone ever rigorously attempted to identify market risk for their style, or for the reporting period? I have become quite cynical about the whole active management business.

  15. This same arguement was made in "A Random Walk Down Wallstreet" about value funds in the late 90's.

  16. Just to add a bit of information to waht 'Anonymous already provided: Dichev first applied his 'dollar-weighted' concept to mutual funds where the data are easier to come by and which are mostly long-only (although not all of them are). He has been presenting this idea since at least 2004 and published his results in the AER:
    Dichev, Ilia D., 2007. What are stock investors actual historical returns? Evidence from dollar-weighted returns, American Economic Review 97 (1), March: 386-401 .
    In 2006 Morningstar adopted the concept to report dollar-weighted returns on the funds covered by them after having published their own study about the concept. They use the label "investor returns"; see:

    So, it may just be a matter of time until this measure may also be adopted by a hedge fund return service.

    This only strengthens Rick's point that any skilled manager will be haunted by the size of her money-under-management, if there are declining 'returns-to-size' as has been claimed and documented for some time. This is how Berk & Green describe equilibrium in the asset management industry; their JPE article explains why there can be skilled managers, while the typical investor in their funds does not experience any out-performance. In essence, skilled fund managers managers experience inflows until the net return to investors (after fees) conforms to the risk-adjusted typical return for her portfolio. In high fee funds that means that most of the rent from fund manager skills is captured by the fund managers and their employers themselves. That would describe the hedge fund industry even better, since they are certainly high fee managers (the exception being Bernard Madoff - who didn't need high fees to achieve ficticious returns).
    And since returns are very volatile, certainly levered returns, measuring skill is very tricky and the equilibrium process to work itself out may take some time.
    Plus, measuring the actual assets under management may also not such a clear-cut exercise either having to rely on self-reported numbers (not always properly audited).


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