Unstructured Finance

Hedge funds vs mutual funds

May 18, 2011

By Dunny P. Moonesawmy, Head of Fund Research for Lipper in western Europe, Middle East and Africa. The views expressed are his own.

Hedge funds took some heat from the credit crisis as liquidity and transparency became critical factors in investment decision-making. It’s fair to say hedge funds continued to deliver decent returns to investors, but how do they compare to mutual funds if we focus on performance and risk alone?

In 2008, the average return for mutual funds stood at a negative 22.91 percent. At the same time, hedge funds posted average returns of minus 8.37 percent. We might have expected a stronger rebound for mutual funds in 2009 and 2010 than for hedge funds, yet the data shows better average returns for hedge funds in both years. Positive returns in the sector stood at 22.36 percent and 18.08 percent respectively against 21.16 percent and 10.23 percent for mutual funds.

If we look at performance over a longer time frame, mutual funds posted annualized returns of 2.07 percent over 3 years and 1.85 percent over 10 years while hedge funds recorded returns of 8.81 percent and 3.77 percent respectively.

We have a different story on the risk side. Part of the appeal of hedge funds is that they seek to actively manage volatility, but managers struggled to keep volatility under control during the credit crisis. The 3-year annualized standard deviation was higher than mutual funds (19.19 percent against 16.65 percent) and the 10-year figures showed similar results (16.80 percent against 12.44 percent).

If we go deeper into the data, we can note that volatility is strongly linked to the asset class for mutual funds while at the same time performance and volatility are positively correlated. As a simple example, a bond category will tend to have lower volatility and lower performance than an equity category. And likewise, an aggressive diversified fund will likely to have higher performance and volatility than a conservative diversified fund.

To view a graphic of the performance data, click on this link.

DEVIATION

While fund categories are important for hedge funds in order to define the different strategies employed, the risk-return dispersion is more linked to global factors and to individual talents. We get plenty of evidence of global trends dictating whether one strategy outperforms another. For example, while managed futures, short strategies and global macros were the big winners in 2008, long-bias, credit focus and convertible arbitrage took their revenge in 2009 as markets recovered across the board.

It is true, however, that whatever the hedge fund category, there remain wide disparities between performance and standard deviation. The more volatile funds tended to post below-average returns while the best performing funds tended to show lower volatility. This is confirmed when we take into consideration the median values of performance and standard deviation: 3-year average returns stood at 32.36 percent and the median value at 28.82 percent while the 3-year average standard deviation stood at 19.19 percent and the median value at 16.65 percent.

Because of the dispersion of risk-return, fund selection becomes easier than expected. Analyzing a universe of funds over a long period allows the fund selector to identify the best talents in different market conditions.

A strict due diligence process is necessary to analyze fully the management process, and also to consider other factors such as operational risks. Of course, the process must weigh up transparency and liquidity issues, but any post-crisis fund selection would surely factor in these two aspects of a fund portfolio.

In the aftermath of the credit crisis investors still approach hedge funds with caution. But it does not mean that alternative strategies are banned from investors’ portfolio. Far from it: the success of absolute return mutual funds – 185 EU-regulated UCITS funds were launched in 2010 representing assets under management of 7.5 billion euros – might well show that investors are keeping alternative strategy funds up their sleeves waiting for a better market environment before once again entering the hedge fund sphere.

(Editing by Joel Dimmock) ((dunny.moonesawmy1@thomsonreuters.com; +33 1 4949 5009))

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