Key Takeaways
- • Rodney Sullivan and Matthew Wey of the Darden Report find that the average hedge fund delivered risk-adjusted alpha of about 3.7% per year net of fees from January 1994 through December 2008, but that alpha turned slightly negative after fees from January 2009 through December 2022.
- • Equity hedge funds followed the same pattern, with alpha falling to near zero after adjusting for market risk, as the momentum factor became less reliable and managers held lower-quality stocks.
- • Equity and bond market exposure alone explained over 80% of hedge fund return variation post-GFC, up from around 60% earlier, and a multi-factor model with style factors explained nearly 90% of equity hedge fund returns after the GFC.
- • Global macro and managed futures strategies show a parallel decline, with both categories finding it harder to outperform a comparable risk-adjusted stock-bond portfolio.
- • The authors conclude that the era of robust, repeatable hedge fund alpha has passed for the group as a whole, though some managers may still add excess returns and provide portfolio stabilization in severe turbulence.
Summary
Researchers Rodney Sullivan and Matthew Wey, writing in the Darden Report, argue that hedge funds' ability to generate alpha has changed significantly since the 2008-09 Global Financial Crisis. Hedge fund assets under management have grown from around $200 billion at the turn of the millennium to nearly $6 trillion today, yet investors increasingly question whether these strategies still deliver excess returns above a comparable market portfolio and the downside protection that once distinguished them from traditional stock and bond portfolios.
Before the GFC, the average hedge fund provided meaningful risk-adjusted outperformance, with alpha of about 3.7% per year net of fees between January 1994 and December 2008. Equity-focused managers were a major source of this performance, achieving annualized alphas often above 4% by exploiting market inefficiencies, style factors and security selection. After the GFC, the picture reversed. From January 2009 through December 2022, the average hedge fund's market-adjusted alpha turned slightly negative after fees and expenses, which the authors say means hedge funds as a group have failed to outperform a properly risk-adjusted stock-bond portfolio in the post-GFC era.
The authors attribute the decline to several factors. Previously rewarded strategic tilts became widely known and implemented, creating what they describe as too much money chasing too few ideas. The momentum factor generated less reliable returns after 2009, and managers continued to favor lower-quality stocks, which hurt performance. Equity and bond market exposure alone explained over 80% of return variation post-GFC, up from around 60% earlier, and a multi-factor model including value, size, momentum and quality factors accounted for nearly 90% of equity hedge fund return variation after the crisis. Equity hedge fund managers also significantly reduced active risk-taking, which contributed to lower alpha.
The research extends to global macro and managed futures strategies, which the authors describe as previously producing positive alpha and dampening drawdowns. Their value proposition has also eroded post-GFC, although global macro managers still tend to offer somewhat better downside protection than managed futures managers.
The authors argue that paying hedge fund fees for diminishing excess returns may be harder to justify than two decades ago, and that investors should scrutinize active risk-taking and set more realistic expectations about fair fees. They do not predict a sunset for the industry: some managers continue to innovate and may still offer excess returns and serve as portfolio stabilizers during severe turbulence, though the era of robust alpha for hedge funds as a group appears to have passed. Sullivan is the author of "Hedge Fund Alpha: Cycle or Sunset?" and "Hedge Fund Alpha: What about Drawdowns?" in the Journal of Alternative Investments.
Before the GFC, the average hedge fund provided meaningful risk-adjusted outperformance, with alpha of about 3.7% per year net of fees between January 1994 and December 2008. Equity-focused managers were a major source of this performance, achieving annualized alphas often above 4% by exploiting market inefficiencies, style factors and security selection. After the GFC, the picture reversed. From January 2009 through December 2022, the average hedge fund's market-adjusted alpha turned slightly negative after fees and expenses, which the authors say means hedge funds as a group have failed to outperform a properly risk-adjusted stock-bond portfolio in the post-GFC era.
The authors attribute the decline to several factors. Previously rewarded strategic tilts became widely known and implemented, creating what they describe as too much money chasing too few ideas. The momentum factor generated less reliable returns after 2009, and managers continued to favor lower-quality stocks, which hurt performance. Equity and bond market exposure alone explained over 80% of return variation post-GFC, up from around 60% earlier, and a multi-factor model including value, size, momentum and quality factors accounted for nearly 90% of equity hedge fund return variation after the crisis. Equity hedge fund managers also significantly reduced active risk-taking, which contributed to lower alpha.
The research extends to global macro and managed futures strategies, which the authors describe as previously producing positive alpha and dampening drawdowns. Their value proposition has also eroded post-GFC, although global macro managers still tend to offer somewhat better downside protection than managed futures managers.
The authors argue that paying hedge fund fees for diminishing excess returns may be harder to justify than two decades ago, and that investors should scrutinize active risk-taking and set more realistic expectations about fair fees. They do not predict a sunset for the industry: some managers continue to innovate and may still offer excess returns and serve as portfolio stabilizers during severe turbulence, though the era of robust alpha for hedge funds as a group appears to have passed. Sullivan is the author of "Hedge Fund Alpha: Cycle or Sunset?" and "Hedge Fund Alpha: What about Drawdowns?" in the Journal of Alternative Investments.
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