Hedge funds are often perceived as a get-rich-quick scheme, where hedge fund managers by walking on the edge of the law multiply the invested capital. However, things are nearly not like they are presented in some mainstream media.
Hedge funds do employ multiple strategies, combined with some risky approaches such as debt and leverage. By doing so they search for a chance to multiply their gains. An often topic of discussion amongst novice and intermediate investors is what is an average hedge fund return and how it compares to what the average investor might expect from other investment options.
To talk about this topic, several things need to be explained. Important input information includes what types of strategies the funds are using, what are their risk management strategies, and how much they rely on leverage. During the 80s and 90s hedge funds averaged 15%-20% annual returns. That figure dropped in the 2000s to 8%-12%. In the next decade, the numbers continued to dwindle reaching 5%-8%. Most recently, in 2023 hedge funds generated 6.4% average returns.
To better understand this crucial topic, we will go through all the necessary information. We will define hedge funds, explain their strategies, how economic indicators can impact their performance, and the importance of the hedge fund manager’s role.
Key Takeaways
- Hedge Funds are always trying to beat the market - sometimes they win, sometimes lose.
- Their strategies are often complex and risky, which puts them in a position to win and lose big.
- Hedge fund returns have been dropping for several decades. During the 80s there were years with average hedge fund gains of 20%, while in 2023 average returns were at 6.4%.
- Most hedge funds perform better than mutual funds and the S&P 500 index, especially in bear markets, due to their potential for higher returns.
Hedge Funds Definition
Hedge funds started to develop after World War II. The first hedge fund manager is considered to be Alfred Winslow Jones. He made a decision to combine long positions with short selling to hedge against market risk. He wanted to outperform the market with lower risk. By the 80s several new strategies were added bringing diversification to hedge funds.
What we today consider a hedge fund is essentially an investment vehicle that pools money from investors. What sets it apart from other types of funds is that investors need to be accredited to partake in the investment process. Meaning, that they need to be fairly wealthy individuals who have enough capital on hand, and can sustain losses due to high-risk strategies. When seeking a hedge fund investment, it is crucial to conduct thorough research and consider important questions about the fund's strategy, risk, and management.
In contrast to ETFs, and other mutual funds, hedge fund managers aim to beat the market at every instant. They utilize diverse strategies and leverage to generate alpha. Also, they are exclusively actively managed. This means that managers are actively making investment decisions with the goal of beating the market.
While the majority of other funds tend to reflect the performance of benchmark indexes, hedge funds take one step more in their attempt to beat the indexes. They will rather choose to take massive risks and lose than settle for mediocre gains.
However, to beat the market is not that easy. Periods of volatility impacted by different types of crises impact the market making them unpredictable. Navigating through all these obstacles is not an easy task, and that results in many hedge funds struggling to beat the benchmark indexes.
Historical Overview Of Hedge Fund Returns
Hedge Funds In The 80s
How the hedge funds perform is highly impacted by the conditions on the market, and other contributing economic factors. The 80s saw a recovery from the stagflation of the 70s. The United States economy managed to make a rebound, while equity markets started to outperform. This was a great foundation for hedge funds to hunt for high-performing investments.
It wasn't the perfect decade. There were several highly volatile periods, like the market crash of 1987, and the infamous Black Monday. However, hedge funds in the majority managed to get atop by using leverage. They preferred short-selling and market timing strategies to get above-average returns.
Top performers of the decade were George Soros with his global macro strategy of making bets against local currencies, and Bruce Kovner from Caxton Associates with his trademark special situations strategy. There was also Julian Robertson from Tiger Management who managed to multiply its capital from $8 million in 1980 to $7.2 billion in 1996.
Hedge Funds In The 90s
The next decade was marketed by significant innovation and the inclusion of technology into hedge fund strategies. Quantitative trading was the new thing, where hedge funds adopted quantitative technologies offered by increasing computing power and potential for analytics.
James Simons the founder of Renaissance Technologies was the founder of this innovative approach that opened the door to other managers to exploit the power of computers.
Besides quantitative trading, sector-focused investments, and event-driven strategies were top picks for many managers. The development of the tech sector allowed hedge funds to focus on this specific sector, and invest in it enormous amounts of capital. This resulted in a dot-com bubble, where hedge funds got mixed results, depending on their preparation, and reading of the market.
The decade resulted in solid hedge fund annual gains of 14.2%. Funds still couldn't beat the S&P 500 Index which delivered in the same period 18.8%.
Of course, there were outperformers, including Renaissance Technologies (roughly 30% gain), Soros Fund Management, famous for breaking the British Pound, and Tudor Investment Corporation (only in 1990 it gained 87.4%).
Hedge Funds In The 21st Century
The new century started off with major dislocations in the market triggered by the dot-com bubble which implicated major tech companies. This high-volatility period was fueled by the 9/11 attacks. The best-performing corporations were those that opted for diversified portfolios and strategies. Global macro and event-driven strategies were standouts in this period.
The average hedge fund was again triggered by the housing bubble in the mid-2000s. This period was cumulated by the Global Financial Crisis 2007-2008. Of course, some managers delivered strong performance, including Warren Buffet, and Carl Icahn.
This decade plagued with volatility and increasing risk ended with decreasing overall hedge fund returns to high single figures, and in some situations, lower teens.
After every crisis, there is a recovery period, and this time was no different. Market returns and strong performance were a trademark of early 2010. Central bank policies bring positives to hedge fund performance all around the industry.
The hedge fund industry was on the rise, specifically, those funds that used global-macro, event-driven, and long/short equity strategies. These could capitalize on market dislocations and volatility.
Continued low interest rates pushed investors to seek alternative investment vehicles, like hedge funds in search of higher returns.
Most noted winners in this period were the Medallion Fund from Renaissance Technology with a gain that was often above 30%. They achieved this due to their innovative and effective use of quantitative trading strategies.
Bridgewater Associates managed by Ray Dalio is another worthy mention. The fund gains reached high teens in almost an entire decade. When put into perspective the fund delivered solid 10.4% annual gains since inception, with only three losing years.
D.E. Shaw Group with their composite fund is another standout in this period. Their combination of quantitative, event-driven, and fundamental analysis strategies brought solid annual gains to the investors. Double-digit gains during this decade were almost exclusive.
The start of the 2020s with the onset of the COVID-19 pandemic was difficult for everyone, and hedge funds were not excluded. It triggered major market volatility resulting in major market downturns. Strategies with a long focus struggled the most, while some funds that resort to global macro and quantitative trading, managed to stay afloat.
Due to major market turbulences, many funds turned to lower-risk options, like government bonds, or investing in gold.
Recovery came in 2021 and 2022 pushed by massive fiscal and monetary stimulants provided by governments and central banks. These actions helped funds with a long bias and growth focus.
However, this didn't last, and soon inflation hit triggering another wave of market volatility. This scenario forced hedge funds to change their strategies and hedge their portfolios against high inflation.
This period saw several innovative trends emerging, and from the looks of things are here to stay. Cryptocurrencies and blockchain which were deemed a passing trend have become an almost equal type of asset like traditional ones.
The impact of machine learning and processing large amounts of data pushed new players into the field like Pantera Capital and Multicoin Capital.
Average hedge fund returns in the 2020s are on the line between single and double digits. In 2020 average hedge fund delivered 11.8%, while in 2021 that figure dropped to 10.3%. A year later hedge fund industry went into the red, with average returns reaching negative -4.25%. The only clear winners were macro-oriented funds with a positive return of 9.31%.
In 2023 an average hedge fund delivered 6.4%. One of the clear winners was Coatue Management led by Philippe Laffont with a gain of 21.5%. Long/short equity funds came on top, followed by long-biased and event-driven hedge funds.
Factors That Influence Hedge Fund Returns
When talking about what can influence hedge fund performance key factors that need to be mentioned are the strategies used by the fund, market and economic factors, and risk management strategy used by the fund.
Also, other factors, like geopolitical events, technological advancements, and investor sentiment can impact lower or higher returns.
One factor that was not so common for hedge funds in the past, that became apparent after the GFC is regulatory changes. Hedge funds enjoyed low regulatory scrutiny from the regulatory bodies. However, after some unethical, and borderline criminal activities during the GFC, regulators turned another leaf on hedge funds.
Maybe the most triggering factor is the market conditions. Overall market performance can play a major role in the returns of hedge funds. The market can be bull or bear, and while bull markets favor long-biased strategies, bear markets can benefit from short-term investments that include hedging protection.
The second part of the puzzle is a strategy that a fund utilizes. Depending on other factors, including the market, some strategies will fare better in one situation, while others will deliver lower returns, or end up with losses. Hedge funds often use derivatives, short sales, or non-equity investments, which tend to be uncorrelated with broad stock market indexes, thus reducing total portfolio risk.
Hedge funds often think over their approach depending on the market landscape, and adapt so they can tackle new situations. Also, there are strategy specialized funds, that rarely decide to mix things up and decide to specialize. Those funds can find ways to benefit in all market conditions.
How Strategy Can Impact Returns
One of the features of hedge funds is their wide array of strategies that can be employed to generate gains. They offer a diversity effect to hedge fund operations and provide them an opportunity to mix things up.
Employing different strategies is also compelling to investors. Before they commit their capital to a fund, they should know their preference, goals, and best ways to achieve them.
Long/Short Equity
Long/short equity strategy is the basis of the hedge fund industry and one of the reasons is the potential to generate positive returns in both bear and bull markets. Long positions thrive while the market is on the rise, while short books deliver positives when the market is in the bear phase.
To be able to get the best out of this strategy the manager must be top-notch in picking stocks and understanding the market landscape. Hedge funds that prefer this strategy, annually bring 7%-12% gains.
Global Macro
Global macro strategy in its core is reliant on macroeconomic trends and global events. Funds and managers that prefer this approach must possess a deep understanding of potential future developments in specific markets and industries. If they have knowledge that a specific event will trigger a market to go up or down in a certain period, finding assets that could benefit from it could generate massive gains.
This is often a gamble because it is difficult to predict how the market will act. One thing is to know that an event will happen, but how will it reflect on the market is a bit different question. Returns are highly inconsistent and may vary between major wins and complete losses. Depending on the macroeconomic predictions and capability of the manager, these funds deliver 6%-10% on a yearly basis.
Merger Arbitrage
Merger arbitrage is a strategy that includes making profits from differences in stock price before and after merger situations. This is a lower-risk strategy that also delivers smaller returns. Also, comes with a risk in the case that a merger situation falls through.
Aggressive strategies can deliver higher returns, but merger arbitrage returns are more stable. Managers need to have a keen eye for ongoing and potential mergers, and what way they can go. If a fund decides to specialize in this niche, usually they bring 4%-8% per year.
High-Frequency Trading
With the implementation of new technologies, hedge funds have several new tools to use on the market. One of them is algorithms that help them to execute trades a very high speeds. This allows them to catch small price movements.
It is considered to be a lower-risk strategy, but it demands a high investment in the technology needed for the execution. If the fund conducts large amounts of small trades, this approach can amass solid gains. Risks lie in the competition and market conditions. High-frequency trading hedge funds annually rein in between 8% and 12%.
Distressed Securities
This is a high-risk investment approach that puts focus on securities in companies that are either in distressed financial situations or undergoing bankruptcy. It can come as a highly rewarding strategy if the restructuring goes well. In case of a failure, the whole investment goes down the drain.
The period for the returns to bear fruit depends on the case. In some situations, if the company has some good foundations, the benefits can come around quickly. If the company is in serious trouble, it may take a longer period to reap the gains. Distressed investing has significant potential for gains, and funds that have capable portfolio managers bring in between 7% and 15% per year.
The Importance Of Hedge Fund Managers And Their Due Diligence
Hedge fund managers play a crucial role in the success and gains that the fund will generate. The strategy they implement is usually complementary to the fund's preferences. From there it is the manager's job to identify potential lucrative investments.
Every manager should focus on their understanding of financial markets, economic trends, and asset classes. Only then they can make informed decisions that can result in a positive impact.
Before they make an investment decision, they should conduct their due diligence. This includes finding the good and bad sides of a potential security. Once they know what to look out for they can plan a risk management strategy.
To properly prepare to make a move for security, a manager needs to analyze not only the company but also the sector in which it operates. Managers need to know potential competitive advantages, toughest competitors, and an outlook for the industry as a whole.
After the capital has been put into play, the manager still needs to keep his sight on the investment. Sudden market shifts or sector-related events can bring both good and harm to the holding. Remaining vigilant is one of the ways to protect the investment and to maximize the profit.
When the fund has all the pieces of the puzzle in place, including the managers utilizing their preferred strategies, wide knowledge and understanding of the markets, and when external factors go their way, funds can expect higher returns. If the fund is dysfunctional, using the wrong approaches, with the executives out of their depth, positive returns are a bridge too far.