The Alternative Investment Management Association has refuted claims of underperformance and poor value by hedge funds, commissioning a study jointly with KPMG that shows the industry has delivered market-beating returns over a 17-year period.

Hedge funds achieved an average return of 9.07 per cent in the period 1994–2011 after fees compared to 7.18 per cent for stocks, 6.25 per cent for bonds and 7.27 per cent for commodities, according to the report by Imperial College’s Centre for Hedge Fund Research, called The value of the hedge fund industry to investors, markets, and the broader economy.

Hedge funds have come under fire in recent months for delivering lacklustre returns in 2011 and making a patchy start to 2012. Hedge funds fell 5.26 per cent last year, according to Chicago-headquartered Hedge Fund Research, underperforming the S&P 500 for example.

The Morningstar MSCI Composite Hedge Fund Index crept up 0.1 per cent in March to end the first quarter of 2012 up by 3.3 per cent, according to data released by Morningstar yesterday. Meanwhile, the S&P 500 finished the quarter up 12.6 per cent and the Morningstar MSCI North America Hedge Fund Index rose 5.5 per cent.

Manager versus investor gains

Using HFR data, KPMG says hedge fund investors keep around 72 per cent of the profits on their capital while managers retain a 28 per cent share. This is taken into account in the report’s net return estimate of 9.07 per cent over the period. Inactive funds were also included, as the major hedge fund trackers began collecting data on inactive funds in 1994.

In the 1994-2011 period, hedge funds made aggregated annual losses in three years, which were 2002, 2008 and 2011, with 2008 being the most dramatic loss by far at -20.48 per cent.

Risk-adjusted returns

The Sharpe ratio – a measure of risk-adjusted performance – is 0.76 for hedge funds for the examined period, compared to 0.23 for global stocks, 0.68 for global bonds and 0.16 for commodities. Meanwhile, the standard deviation of performance, at 7.2, is higher than for global bonds but lower than for equities and commodities, the study claims.

Other asset classes are measured using the MSCI World Total Return Index for global stocks, the JP Morgan Global Aggregate Bond Total Return Index for global bonds, and the S&P GSCO Commodity Total Return Index for commodities, all between January 1994 and October 2011.

Correlations between hedge funds and other asset classes are shown to rise during recessions in the report, but “only slightly,” the authors say, “suggesting that hedge funds do not threaten the stability of the financial system”.

Using regression analysis of hedge fund excess returns against the excess returns of other asset classes, the authors of the report find that “most of the hedge fund performance is explained by alpha, not beta (that is exposure to systemic risk).” They estimate that around 76 per cent of hedge fund performance is due to alpha.

Diversification benefits

To examine the role of hedge funds as part of a wider portfolio the study compares two hypothetical portfolios: one with an equal-weighted allocation to hedge funds, global stocks and bonds and one with a 60/40 asset allocation between stocks and bonds. In this case, with the equal-weighted portfolio, the Sharpe ratio rises from 0.34 to 0.53.

“Using equal-weighted hedge fund index data from 1994 to 2011, we demonstrate that an equal weighted allocation to hedge funds, stocks and bonds delivers significantly higher Sharpe ratio and lower tail risk than the institutional investor’s standard 60/40 allocation in stocks and bonds,” the study says.