hedge fund performance: 1990-1999

CFA Institute

Hedge Fund Performance: 1990-1999Author(s): Bing LiangSource: Financial Analysts Journal, Vol. 57, No. 1 (Jan. - Feb., 2001), pp. 11-18Published by: CFA InstituteStable URL: http://www.jstor.org/stable/4480291 .

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Hedge Fund Performance: 1 990-1 999

Bing Liang

Using a large database, I studied hedgefund performance and risk during an almost 10-year period from 1990 to mid-1999. The empirical results show that hedgefunds had an annual return of 14.2 percent in this period, compared with 18.8 percentfor the S&P 500 Index. The S&P 500 is much more volatile, however, than hedgefunds as a whole. Annual survivorship bias for hedge funds was 2.43 percent. I examined year 1998 in detail because hedge funds were heavily affected by the global financial market tumble in that year. For example, the highest volatility for hedge fund returns occurred in 1998, and morefunds died andfewer were born in 1998 than in any other year of the period studied. Fewfunds changed theirfee structures. In those that did, thefee changes were performance related; poor performers lowered their incentivefees.

J edge funds are one of the fastest grow- ing sectors in finance. Recently, hedge funds have been making the headlines almost daily. Since the 1997 Asian

financial crisis and the 1998 near collapse of Long- Term Capital Management, hedge fund problems, however, have caught the eye of regulators as well as investors and money managers.

Despite this attention, the public has a limited understanding of the hedge fund industry. The main reason is that the information on returns, risks, and fee structures of hedge funds is largely unavailable to the public because hedge funds are either nonregulated U.S. partnerships or offshore corporations that are not required to disclose this information. The lack of regulation gives hedge fund managers a great deal of flexibility in operat- ing inside their "black boxes," which generates tremendous curiosity from the investment commu- nity. In addition, a lot of the attention was focused on a few hedge funds while little attention was being paid to the industry as a whole.

A few commercial data vendors/consultants do possess hedge fund data. Examples are Hedge Fund Research (HFR), Managed Account Reports (MAR), and TASS Management Limited.1 The few academic studies on hedge funds are usually based on these databases. For example, Fung and Hsieh (1997a) used combined data from Paradigm LDC and TASS. Ackermann, McEnally, and Ravenscraft (1999) combined data from HFR and MAR. I used

HFR data in a 1999 study. An exception is Brown, Goetzmann, and Ibbotson (1999), who used the hand-collected data from the U.S. Offshore Funds Directory.

In an earlier study (Liang 2000), I pointed out the differences between hedge fund databases and noted errors in some of the databases. For example, returns, assets, fees, and investment style classifi- cations may be different in the HFR database than they are for the same funds tracked by TASS. I suggested that the TASS database should be used for academic research because of its relative com- pleteness and accuracy.

The study reported here involved more funds and a longer time horizon than previous studies. I used data as recent as July 1999, which allowed an examination of how recent financial crises have affected the hedge fund industry. Moreover, I examined not only live funds but also dead funds, so I was able to study the issue of survivorship bias in hedge fund research. Particular attention is focused here on 1998 because it was an especially challenging year for the hedge fund industry. In 1998, Russian debt defaulted, Long-Term Capital Management (LTCM) almost collapsed, and many other hedge funds suffered similar losses.

Data The data on fund returns, assets, fees, investment styles, and other fund characteristics came from TASS. As of July 1999, the TASS database covered 2,016 hedge funds, including 1,407 live funds and 609 dead funds. Total assets under management by these funds were about $175 billion. Among the 2,016 funds, the majority reported returns, net of various fees, on a monthly basis. After the 95 funds

Bing Liang is assistant professor offinance at Weather- head School of Management at Case Western Reserve University.

January/February 2001 11



Financial Analysts Journal

with gross returns and quarterly returns were deleted, 1,921 funds remained in the study.

TASS enumerates 15 investment styles: top- down macro, bottom up, short selling, long bias, market neutral, opportunities, relative value, arbitrage, discretionary, trend follower, technical, fun- damental, systematic, diverse, and other. Note that these styles may overlap. For example, a fund might use both long-bias and short-selling strategies.2

1990-99 Performance Hedge fund returns and risk by year and by investment style are reported in Table 1. In the nearly 10-year period, the average monthly return of all hedge funds in the sample was 1.11 percent a month, or 14.2 percent a year. The best year was 1993, with an annualized return of 27.0 percent, and 1994 was the worst performance year, with an annual return of -0.6 percent. The most volatile year for hedge funds, however, was 1998, when many hedge funds ran into trouble because of the Russian debt crisis, which followed so soon after the Asian financial crisis in 1997. The average standard deviation of returns across the 15 styles in 1998 was 2.57 percent, much higher than in the other years. Note that this 10-year period is roughly coin- cident with the longest bull market in U.S. stock market history. The average annualized return for the S&P 500 was 18.8 percent for this period.

Among investment styles, winners were the opportunities and long-bias strategies and losers were the systematic and technical strategies.

Hedge Funds versus S&P 500 Index. The cumulative monthly returns of the hedge funds are plotted against the cumulative monthly returns of the S&P 500 from January 1990 to July 1999 in Figure 1. A $1.00 investment in all hedge funds in January 1990 would have grown to $3.39 in July 1999. The same investment in the S&P 500 would have grown to $4.79 over the same time period. Note that the cumulative monthly return for all hedge funds is above that for the S&P 500 until the end of 1996. The substantial growth in the U.S. equity markets from 1997 to 1999 gave the S&P 500 a huge lift, which contributed to the final result of this competition between hedge funds and the S&P 500. Survivorship bias may have played an impor- tant role in these results: The TASS database started to include liquidated funds only in 1994, so the superior performance of hedge funds prior to 1994 may result from ignoring the dead funds.

According to Figure 1, the live-fund group significantly outperformed both the dead-fund group and all hedge funds. For example, a $1.00

investment in the dead funds would have grown to only $1.84, compared with the $3.99 for the live- fund return. The performance difference between the live and the dead funds is significant only after 1994, so again, survivorship bias may be involved in the early results.

Although the S&P 500 won the return competition during this 10-year period, its returns were more volatile than those of hedge funds as a group. From January 1990 to July 1999, the standard deviations of monthly returns were as follows:

S&P 500 3.89 percent All funds 1.67 Live funds 1.70 Dead funds 1.91

As pointed out in the previous studies, hedge fund strategies have low correlations with each other and low correlations with the traditional asset classes.3 Moreover, hedge funds can effectively reduce risk by doing dynamic hedging, combining long and short positions, and diversifying their portfolios across different financial instruments. Note the higher volatility of the dead-fund group; the trading strategies of these funds were riskier than those of the live funds, which may have attributed to their disappearance.

To compare risk-adjusted returns, I calculated the Sharpe ratios, which were as follows:

S&P 500 0.27 All funds 0.41 Live funds 0.48 Dead funds 0.08

Hence, on a risk-adjusted basis, hedge funds outperformed the S&P 500 during the study period. Readers should accept these results with caution, however, because the survivorship bias in the early years when data on the dead funds were not included may be underestimated.

Survivorship Bias. Survivorship bias results from the fact that poorly performing funds disappear over time; the calculation of fund returns based on surviving funds only can generate an upward bias in fund returns. So far, studies about hedge fund survivorship bias have reported different results. For example, Fung and Hsieh (2000) docu- mented an annual survivorship bias of 1.5 percent. Brown, Goetzmann, and Ibbotson reported an annual survivorship bias of 3 percent for offshore funds.4 Ackermann et al. found, however, that the survivorship bias is small-an average magnitude of 0.16 percent a year. These conflicting results about survivorship bias may be reconciled by the fact that the two major hedge fund databases contain different numbers of dissolved funds (Liang 2000).

12 ?2001, Association for Investment Management and Research?b



Hedge Fund Performance: 1990-1999

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Figure 1. Hedge Fund Returns versus S&P 500 Returns, 1990-99

Cumulative Return ($) 6

5

4

3

2

90 91 92 93 94 95 96 97 98 99a

S&P 500 All ... i. Live Dead

a Through July.

On average, as calculated from the last column of Table 2, about 8.54 percent of funds disappear each year. If the main reason for a fund's disappearance is poor performance, then an upward survivorship bias will exist in fund returns.5 Table 3 reports by year the average percentage monthly returns of the groups of live and dead funds as well as of the S&P 500 and the group of all funds. The averages shown in the bottom row indicate a substantial return difference between the live group and the dead group-1.22 percent versus 0.55 percent.6 Following previous literature, I calculated survivorship bias as the return difference between the surviving funds and all funds. The result indicates that the bias was 0.14 percent a month or 1.69 percent a year during the 10-year period. Because TASS did not begin collecting the dead-fund data until 1994, however, a meaningful calculation of survivorship bias should be based on data from 1994 and on. For that period, the return difference between the surviving funds and all funds was 0.20 percent a month, 2.43 percent a year. This higher percentage is the true survivorship bias of hedge fund returns. The 2.43 percent a year is about half- way between the 1.50 percent bias in Fung and Hsieh (2000) and the 3.00 percent bias in Brown, Goetzmann, and Ibbotson for offshore funds, and it is close to the 2.24 percent bias I previously found (Liang 2000). The positive survivorship bias con-

firms that the main reason for a fund's disappearance is poor performance.

Hedge Funds in 1998 The year 1998 was a disaster for the hedge fund industry. On August 17, Russia defaulted on its ruble debt and domestic dollar debt. Trading in Russian debt was halted, the stock market tum- bled, and the ruble was depreciated. The crisis in Russia soon spread to the financial markets in other countries and caused a panic among investors. In response, investors poured money into high-quality debt instruments, such as U.S. Trea- sury securities and other government debt. Credit spreads between high-quality and risky debt thus widened, which reversed a multiyear trend toward spread tightening. In addition, because of massive sell-offs, liquidity risk premiums also increased for corporate bonds, mortgage-backed securities, and other illiquid securities.

As a result, hedge funds that were betting on convergence in yield spreads and invested heavily in the fixed-income security markets (such as LTCM) suffered tremendous losses and faced mar- gin calls from their lenders. Under such pressure, the hedge funds were forced to liquidate their portfolios, deleverage their positions, or go out of business. Consequently, hedge fund lenders- investment banks, commercial banks, brokerage

14 ?2001, Association for Investment Management and Research?




Table 2. Hedge Fund Attrition Rate, 1993-99

Year Start Funds Born Funds That Died Year End Attrition Rate

Pre-1993 - - 540

1993 540 234 - 774

1994 774 242 32 984 4.13%

1995 984 229 77 1,136 7.83

1996 1,136 245 142 1,239 12.50

1997 1,239 262 124 1,377 10.01

1998 1,377 202 179 1,400 13.00

1999a 1,400 60 53 1,407 3.79

Total 1,474 607

Note: The attrition rate is defined as the ratio of the number of funds dying during a year to the number of funds at the beginning of the year.

aThrough July.

Table 3. Hedge Fund Survivorship Bias, 1990-99 (standard deviations in parentheses)

Year S&P 500 All Funds Live Funds Dead Funds Bias 1990 -0.14% 1.47% 1.32% 1.80% -0.15%

(5.31) (1.13) (1.03) (1.96) 1991 2.34 1.53 1.70 1.15 0.18

(4.56) (2.50) (2.45) (2.70) 1992 0.64 0.91 0.94 0.87 0.03

(2.13) (1.04) (1.01) (1.30) 1993 0.81 1.81 2.05 1.45 0.24

(1.77) (1.25) (1.40) (1.19)

1994 0.15 -0.09 0.02 -0.25 0.11 (3.04) (0.92) (1.03) (0.83)

1995 2.70 1.14 1.49 0.53 0.36 (1.50) (1.10) (1.23) (1.04)

1996 1.79 1.26 1.52 0.65 0.26 (3.15) (1.60) (1.71) (1.40)

1997 2.52 1.26 1.41 0.62 0.16 (4.60) (2.12) (2.12) (2.22)

1998 2.30 0.25 0.44 -1.31 0.19 (6.21) (2.13) (2.13) (2.16)

lggga 1.29 1.44 1.47 -0.43 0.03 (3.93) (1.80) (1.80) (1.88)

Average 1.45 1.08b 1.22 0.55 0.14

Note: The survivorship bias is calculated as the monthly return difference between surviving funds and all funds.

aUntil July. bSlightly different from 1.11 percent in Table 1 because the styles are overlapping in Table 1.

houses, and other counterparties-tightened their credit to hedge funds, even though some of them had seldom requested collateral or a "haircut" before.7 This kind of credit squeeze, together with investor withdrawal, created more pressure and losses for hedge funds because such funds as fixed- income arbitrage funds and global macro funds rely heavily on leverage to achieve large positions and to boost returns.

Monthly Returns. This section addresses hedge fund returns in each month of 1998 and also in the first and second halves of 1998. Figure 2 shows the 12 monthly returns for hedge funds in 1998. I expected August to be the worst month for hedge funds because the default on Russian debt in the middle of the month triggered a ripple effect in the global economy. And indeed, the loss in August reached 4.88 percent for the total group of funds in





Figure 2. Hedge Fund Returns, 1998

Return (%)

4

-2

-3

-4

1/98 2/98 3/98 4/98 5/98 6/98 7/98 8/98 9/98 10/98 11/98 12/98

this study, far beyond the gains and losses in other months. Some recovery occurred in September and October, however, after the U.S. Federal Reserve coordinated 14 of the largest financial institutions to bail out LTCM and lowered key interest rates to ease the crisis. By November, LTCM had already made a profit and returned $2.6 billion of the $3.63 billion the bailout group injected into the fund. The fund's founder, John Meriwether, had even been approved by the 14 institutions to launch a new hedge fund.

As a group, hedge funds generated returns of 2.36 percent and 1.95 percent in, respectively, November and December of 1998. (From January 1999 to July 1999, hedge funds produced an average monthly return of 1.44 percent.) When 1998 is broken down into two halves, the average monthly return in the first half turns out to have been 0.61 percent and in the second half, -0.12 percent. This difference is statistically significant at the 1 percent level (t = 5.99). Hence, the poor performance of hedge funds in 1998 was driven primarily by the poor returns in the second half when the global financial markets experienced profound turbulence.

Deaths and Births. As expected, more funds died in 1998 than in other years. Table 2 shows that the total number of dead funds in 1998 was the highest of any full year in the 1994-98 period. Some 29 percent of the 607 total dead funds for the period died in 1998. The number of births, 202, was the lowest that year of all the full years shown in Table 2. The fund attrition rate in 1998 was 13.0 percent, much higher than the 8.5 percent average from 1994 to 1999. Table 4 shows that among the 179 dead funds in 1998, 68 died in the first half and 111 died

in the second half. In contrast, among the 202 newborn funds, 117 were born in the first half versus 85 in the second half of 1998.

Table 4. Birth and Death of Funds, 1998

Month Birth Death

January 36 6

February 15 8

March 16 13

April 19 13

May 16 8

June 15 20

July 32 29

August 20 18

September 9 17

October 2 14

November 8 11

December 14 22

Total 202 179

Fee Changes and Fund Performance. The median management fee for hedge funds is 1 percent of fund assets, and the median incentive fee is 20 percent of profits (see Ackermann et al. and Liang 1999). In general, management fees and incentive fees are stable; once hedge funds determine their fee structures, the funds seldom change them. For example, of the 2,016 funds in this study, only 12 funds changed management and/or incentive fees from 1997 to 1998.8 These fee changes and the performance of the corresponding fund in 1998 are reported in Table 5. Among the 12 funds that changed fees, 8 funds lowered their management





fees and 4 increased them; 7 funds lowered incentive fees, and 5 increased them. The average management fee change for these 12 funds in 1998 was -0.67 percent, compared with the average incentive fee change of -5.1 percent. Therefore, among the 12 funds, not only did more funds reduce management or incentive fees than raised them but the magnitude of the reductions was larger than the magnitude of the increases.

Table 5. Fund Fee Changes and Performance, 1998

Incentive Management Fund 1998 Return Fee Change Fee Change

1 -1.91% -20.0% 0.50%

2 -0.57 -20.0 -2.75

3 2.17 2.5 1.00

4 -8.95 -5.0 -0.50

5 0.18 20.0 1.00

6 -0.53 -20.0 -1.50

7 0.62 -5.0 -0.50

8 1.01 5.0 -0.10

9 0.16 20.0 1.00

10 0.96 5.0 -1.00

11 0.05 -24.0 -3.50

12 -0.39 -20.0 -1.70

Average -0.60 -5.1 -0.67

Note: If a fund changed fees, the change usually occurred at year- end. Therefore, the fee change here is from the end of 1997 to the end of 1998. Change represents the fee in 1998 minus the fee in 1997.

For the seven funds with reduced incentive fees, the average monthly return in 1998 was -1.67 percent, compared with 0.90 percent for the five funds with increased incentive fees. More interest- ing is that the seven funds with negative fee changes in 1998 had an average monthly return of 2.14 percent in 1997, whereas the five funds with positive fee changes in 1998 had an average return of 1.74 percent in the previous year. The performance of funds that reduced fees was substantially below their performance in 1997. Evidently, in line with the design of incentive fees, poor performance

is a major motive for funds to reduce their incentive fees. The result also suggests that a fund changes its incentive fee on the basis of not only the current year's performance but also that of the previous year's performance.

Conclusion Using a large sample, I investigated hedge fund returns and risk over the period of 1990 to mid- 1999. I examined in particular the year 1998 to see the impact of the global financial crisis on the hedge fund industry. I also studied the issue of survivorship bias in reports of hedge fund performance.

Hedge funds enjoyed sizable returns during this 10-year bull market. The average annualized return for all hedge funds was 14.2 percent, compared with 18.8 percent for the S&P 500. Although the total return for the index was higher, hedge funds as a group were much less volatile than the index because of the funds' use of cross-style diver- sification, dynamic hedging, cross-border investing, and a variety of nontraditional financial instruments. During this time period, hedge funds had a Sharpe ratio of 0.41, much higher than the 0.27 for the S&P 500. Hedge funds apparently offer a better risk-return trade-off than pure equity trading strategies. Empirical results show that the average survivorship bias for hedge fund returns is about 2.4 percent a year.

Hedge funds as a whole were severely affected by the economic crises of 1998. More funds died that year than in any other year studied, especially in the second half of 1998 when Russia defaulted on its debt. In 1998, the number of dead funds was the highest and the number of newborn funds was the lowest since 1993; 1998 also produced the highest volatility in hedge fund returns.

In general, few funds change incentive or management fees. Consistent with the design of incentive fees, changes in fees were found to be performance related: Funds that performed poorly in 1998 lowered their incentive fees.

This research was supported by a grantfrom the Weath- erhead School of Management at Case Western Reserve University. I am grateful to TASS Management for providing the data.

Notes 1. The other big name is Van Hedge Fund Advisors, but their

data are not available to academic researchers. In general, hedge funds report to data vendors voluntarily. Because

hedge funds are not allowed to advertise to the public, they view this voluntary reporting as a way to distribute their fund information and attract investors.





2. Although the styles are overlapping, all funds were classi- fied as either live or dead funds under each style.

3. See Fung and Hsieh 1997a, Ackermann et al., and Liang 1999. An individual style or individual hedge fund, however, depending on the investment strategy and what financial instruments are used, may be more volatile than hedge funds as a group.

4. I found (Liang 1999, 2000) that offshore funds are riskier than U.S. funds.

5. One might argue that a hedge fund voluntarily stops reporting to data vendors when it is doing so well that it does not need any more investors. This explanation is unlikely, however; the major reason for a fund's disappearance is proba-

bly that the fund significantly underperformed the surviving funds.

6. The 1.08 percent return for all funds is slightly different from the 1.11 percent given in Table 1 because in Table 1, funds could be in more than one category because of overlapping investment styles.

7. A haircut is the difference between the market value of an asset posted as collateral and the value attributed to such an asset by a lender in determining whether the collateral has been met.

8. Funds that died before 1997 may have changed fees, but we do not have the fee information to evaluate them.

References Ackermann, C., R. McEnally, and D. Ravenscraft. 1999. "The Performance of Hedge Funds: Risk, Retum and Incentives." Journal of Finance, vol. 54, no. 3 (June):833-874.

Brown, S.J., W.N. Goetzmann, and J. Park. Forthcoming 2001. "Careers and Survival: Competition and Risk in the Hedge Fund and CTA Industry." Journal of Finance.

Brown, S.J., W.N. Goetzmann, and R.G. Ibbotson. 1999. "Offshore Hedge Funds: Survival and Performance 1989-95." Journal of Business, vol. 72, no. 1 January):91-117.

Brown, S.J., W.N. Goetzmann, R.G. Ibbotson, and S.A. Ross. 1992. "Survivorship Bias in Performance Studies." Review of Financial Studies, vol. 5, no. 4 (Winter):553-580.

Fung, W., and D.A. Hsieh. 1997a. "Empirical Characteristics of Dynamic Trading Strategies: The Case of Hedge Funds." Review of Financial Studies, vol. 10, no. 2 (Summer):275-302.

. 1997b. "Survivorship Bias and Investment Style in the Returns of CTAs." Journal of Portfolio Management, vol. 24, no. 1 (Fall):30-41.

. 2000. "Performance Characteristics of Hedge Funds and Commodity Funds: Natural versus Spurious Biases." Journal of Financial and Quantitative Analysis, vol. 35, no. 3 (September):291-307.

Liang, B. 1999. "On the Performance of Hedge Funds." Financial Analysts Journal, vol. 55, no. 4 (July/August):72-85.

.2000. "Hedge Funds: The Living and the Dead." Journal of Financial and Quantitative Analysis, vol. 35, no. 3 (September):309-326.

Malkiel, B.G. 1995. "Returns from Investing in Equity Mutual Funds: 1971 to 1991." Journal of Finance, vol. 50, no. 2 uJune):549- 572.




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