Are Hedge Funds Too Big To Beat The S&P?

Stocks And The City

When I started my hedge fund career in 1998, the industry controlled about $200 billion in assets in 3,000 funds. Today, according to BarclayHedge numbers, there are between 10,000 and 15,000 funds investing over $3 trillion. But we seem to have lost a little something along the glorious speedway of growth. Performance, to be precise. As I looked back at the coming of age of hedge funds in the last twenty-something years, I couldn’t help but wonder: when it comes to performance, does size matter?

Not to be fastidiously historical, but from 1998 to 2008, hedge funds beat the S&P in seven out of eleven years, according to the Callan Institute periodic return tables. After 2008, they beat the index…once: in 2018, by 1.1%. Yes, for ten out of the last eleven years, the S&P has outperformed hedge funds, not by a little, but by a whopping 9.4%. I suspect that the poor showing of the hedge fund index is even understated, because it likely has a survival bias − meaning that the worst performing hedge funds go out of business and are not counted in ensuing years.

Why the consistently lackluster returns? My experience as a twenty-year investor in the high yield and distressed markets is that it is hard enough to have ten great ideas to invest $1 billion. When you invest $10 billion and you need a hundred great investments – unique and executable − it’s mission impossible. Call me a fatalist, but invariably the top ten are great, the next ten conceivably good, and so on…until the bottom of the barrel is simply lame. Why not invest more money in the top ten ideas? Because of size limitations: ten distressed situations large enough to invest $1 billion do not systematically exist, at least not without considerably moving the price.

Admittedly, distressed investing, a sub segment of the alternative investment landscape, is a niche market that simply may not accommodate the current size of hedge fund assets. And mine may only be an anecdotal experience. But the same opinion has been publicly voiced by several legendary investors in different markets. In 2016, speaking at the Milken Investment conference, Steve Cohen of Point72 declared that there were “too many players out there trying to do similar strategies”. Dan Loeb wrote in his investment letter the same year that we were “in the first innings of a washout in hedge funds and certain strategies.” Since then, the industry has added almost $1 billion in assets. A superior intuition tells me, however, that both investors referred to the demise and shortcomings of others – their own fund would continue to grow and thrive.

But what if you could extrapolate the question to the entire hedge fund industry, as one asset class, in an analytical rather than subjective manner?

I came upon a fascinating study by Marco Avellaneda, director of the Division of Financial Mathematics at the Courant Institute of New York University, who presciently asked, back in 2005: “Hedge funds: how big is big?” The first concept he introduces is that of capacity: the total amount of money that can be put to work with a given manager or strategy without negatively affecting performance. He corroborates my experience that some strategies (currency trading for example) have greater capacity than others (distressed investing in my example), and consequently that investors, all things equal, should prefer deep capacity rather than niche strategies.

The problem then becomes, can hedge funds deliver outsized risk-adjusted returns in markets that are highly liquid and efficient? His answer is that they can, to the extent that they offer superior investment skills. And since above-average skills are, by definition, in limited supply, as money (i.e. demand for skills) pours into the hedge fund industry, it begins funding managers whose skills “are not superior to those that are needed for index investing”. Here, academia poetically meets practitioners. Mr. Cohen succinctly remarked in the same panel that “talent is very thin” and eloquently added that he was “blown away by the lack of talent.”

And so, comes the point at which hedge funds are too large to beat the market: they are the market. Professor Avellaneda uses a linear regression to study the marginal return of a dollar invested at any given hedge fund size. As expected, the line is well-fitted and downward sloping, meaning that returns diminish as assets increase. He insightfully extrapolates that the hedge fund industry will no longer outperform the S&P 500 past $2 trillion in size.

The industry first reached $2.3 trillion in 2008 (dipping for two years after the Global Financial Crisis before ramping back up to today’s $3 trillion): precisely the year that started the streak of a ten out of eleven-year underperformance. Naturally, one can wish to invest in hedge funds for diversification. But it will take innovations and changes for a trend reversal in outperformance.