Paul Broxup
HEDGE FUND DATA 01/04/2021

Performance dispersion – Why individual fund and manager selection is so critical

Paul Broxup Head of Portfolio Advisory

Earlier this year, Aurum published a Hedge Fund Industry Performance Deep Dive that looked at some of the key themes over 2020, one of which was the extreme levels of hedge fund performance dispersion. As we near the end of the first quarter, I thought it might be interesting to revisit dispersion and, using Aurum’s Hedge Fund Data Engine1 to drill into the numbers a little more, see what stories the data tell.

Firstly – as already discussed in the Industry Deep Dive – it’s clear that dispersion rose dramatically in 2020, and it has remained high so far in 2021. When volatility is elevated it’s not wholly surprising to see a commensurate rise in underlying hedge fund performance dispersion, but it’s interesting to observe that this theme thus far shows no sign of diminution. This phenomenon is likely to have longer-term effects, which we will explore further.

The chart below demonstrates the rolling 12m performance of the top, median and bottom decile hedge funds and Alt-UCITS funds as monitored by the Aurum Hedge Fund Data Engine. The dashed lines are Alt-UCITS and solid lines are hedge funds.

Hedge Fund v Alt UCITS Universe Dispersion – 12m Rolling Returns

Hedge Fund v Alt UCITS Universe Dispersion - 12m Rolling Returns

Source: Aurum Hedge Fund Data Engine. Industry returns Sep 2010 – Feb 2021 (data as at 26th March 2021)

Comparing the median and top decile returns paints a rather stark picture: hedge funds have consistently outperformed their Alt-UCITS counterparts on a rolling 12 month basis over virtually every timeframe going back to September 2010.  On average, the top decile hedge funds delivered an annualised net return of 23.1%, while the top decile Alt-UCITS delivered 17.3%.

There are a number of potential explanations for this. Hedge funds have the ability to utilise leverage to amplify returns, while the Alt-UCITS structure restricts the amount of leverage that a manager can apply to a strategy.  However, even when stripping out levered-performance and normalising for strategy (Alt-UCITS structures lend themselves more readily to certain strategies rather than others) the same performance discrepancy is revealed.

Hedge fund structures and their underlying portfolios also typically carry a liquidity premium over their Alt-UCITS counterparts – which are bound to offer at least fortnightly liquidity, whereas a hedge fund structure isn’t so restricted. This means that managers are able to execute trades intra-month or quarter without having to worry about being forced into exiting a position due to fund flows.  Following on from this certain hedge funds are also able to hold certain underlying assets that typically yield a higher return due to this illiquidity premium. Hedge funds are also given much more investment freedom in how they construct portfolios and can sometimes be highly concentrated, whereas Alt-UCITS funds are subject to minimum diversification requirements.  These constraints can lead to significant performance differences between hedge fund and Alt-UCITS funds.

Given these observations, it’s interesting to note that the bottom decile funds are broadly level. One might have thought that hedge funds would underperform Alt-UCITS as a result of the additional leverage they are able to assume, but any underperformance has not been consistent and is broadly de minimis.

The takeaway from this analysis is clear – on average Alt-UCITS funds underperform hedge funds, and when comparing the top decile of the two groups the underperformance is significant.

So, all else being equal, investors that are seeking exposure to hedge funds would have been better served to invest via true hedge funds, rather than through an Alt-UCITS structure. While many investors into Alt-UCITS may be unable to invest into hedge funds due to structure or liquidity constraints, that certainly isn’t the case for all; so being cognisant of liquidity requirements and making an informed decision can have a material impact on portfolio returns. Moreover, performance dispersion across the hedge fund space is more significant, thus individual fund and manager selection plays an even greater role, and investors must make their selections with care.  Aurum’s view is that significant investment and operational due diligence work is required to achieve an optimal outcome when it comes to hedge fund selection.

  1. Source: Aurum’s proprietary Hedge Fund Data Engine database containing data on just under 4,000 hedge funds representing in excess of $2.9 trillion of assets as at December 2020. Information in the database is derived from multiple sources including Aurum’s own research, regulatory filings, public registers and other database providers. See the disclaimer for further details.