Original Title: Why People Are (Mostly) Wrong About Hedge Fund Returns
Original Author: @systematicls, Macro Analyst
Original Compilation: AididiaoJP, Foresight News
Preface
Many people criticize hedge funds for low returns, but they actually make a conceptual error. Saying hedge funds 'can't beat the market' is like comparing the speed of a boat and a car, and then complaining that the boat is slow on the highway; it’s completely the wrong comparison.
Buying the S&P 500 index (which is the market factor) costs about 0.09% annually. Top hedge funds have annual fee rates of 5%-8% (2/20 fee structure plus various fees). The cost difference reaches 50-80 times.
If both provide the same thing, then investors are fools. But they truly offer different things, and those institutional investors investing billions are not fools.
They buy things that cannot be replicated with money: factor neutrality, high Sharpe ratio, large scale, and unrelated sources of returns. Understanding this will clarify the reasonableness of high fees and no longer lead to comparisons between hedge funds and index funds.
Where does the demand come from?
A common criticism is: 'This year, the S&P rose 17%, while the Castle Fund only earned 9.3%.' For most hedge funds, this criticism may hold, as many funds are just repackaged market volatility.
But this completely misunderstands the product logic of top funds like Citadel/Millennium/Point72. Their goal is not to outperform the market; that is not their mission. Comparing a fund designed to be zero correlated with a 100% stock benchmark is as unreasonable as blaming an insurance policy for not making money.
When you manage a hundred billion pension fund, 60 billion is already in stocks. You don't lack stock exposure; rather, you have too much stock. What you really need are assets that rise when the stock market falls (or at least do not fall with it). You need to diversify risk. More accurately, you want assets that can rise regardless of market conditions and outperform cash.
Sounds great, right? It feels expensive, right? Indeed! True risk diversification is extremely expensive because it is very scarce!
Who are the competitors?
The long-term Sharpe ratio of the S&P 500 is about 0.35-0.5, which means for every 1% of volatility, you gain 0.35%-0.5% of excess return. The Sharpe ratios of the world's top hedge funds are between 1.5-2.5 or even higher.
We are talking about maintaining a Sharpe ratio around 2 for decades, achieving returns unrelated to market volatility, and having much lower volatility. These companies have small drawdowns and recover quickly.
Hedge funds are not expensive versions of the same product but rather a completely different category. Top hedge funds offer advantages that two types of ETFs/index products do not have:
· Factor neutrality
· High Sharpe Ratio
Why is factor neutrality valuable?
To understand the value of factor neutrality, look at this formula:
Return = Alpha + Beta × Factor Return + Random Error
· Alpha = Returns from skill
· Beta = Exposure to systematic factors
· Factor return = Market factor return
· Random error = Individual differences
The beta portion can be replicated using public factor portfolios. Things that can be replicated should only incur replication costs. Replication is cheap: market factors 0.03%-0.09%, style factors 0.15%-0.3%.
Alpha is what remains after deducting all replicable parts. By definition, it cannot be synthesized through factor exposure. This non-replicability is the basis for the premium.
Key insight: Beta is cheap because factor returns are public goods with unlimited capacity. When the market rises 10%, all holders earn 10%, with no exclusivity. The returns of the S&P do not decrease because more people buy.
Alpha is expensive because it is a zero-sum game with limited capacity. For every dollar of alpha earned, someone loses a dollar. The quantity of market inefficiencies producing alpha is limited and will disappear with capital inflow. A strategy with a Sharpe of 2 at a scale of 100 million may only be left with 0.8 at a scale of 10 billion because large-scale trading inherently affects prices.
Factor neutrality (all systematic exposures' beta ≈ 0) is the only truly non-replicable source of returns. This is why the premium is reasonable: not because of the returns themselves, but because this type of return cannot be obtained through other means.
The magic of a high Sharpe ratio
The compounding effect of a high Sharpe will show over time. Two portfolios with the same expected return of 7%, but different volatilities (16% vs 10%), will yield drastically different results after 20 years. The low volatility portfolio has half the probability of loss and much better downside protection.
For institutions that require stable spending, this reliability is worth paying for.
Volatility not only affects the investment experience but also erodes long-term returns mathematically:
Geometric average return ≈ Arithmetic average return - (Volatility²/2)
This is called 'volatility drag'; high volatility portfolios will inevitably underperform low volatility portfolios in the long run, even with the same expected return.
Low volatility portfolios ultimately earn 48 million more, increasing wealth by 16%, even though the 'expected return' is the same. This is not a matter of risk preference but a mathematical fact: volatility erodes wealth over time.
Think like a professional investor
Why are institutions willing to pay a premium of 100 times for factor-neutral funds? Just look at portfolio mathematics to understand.
Assume a standard portfolio: 60% stocks + 40% bonds. Expected return 5%, volatility 10%, Sharpe 0.5. Not bad, but stock risk is quite high.
Add 20% factor-neutral hedge funds: expected return 10%, volatility 5%, Sharpe 2.0, with zero correlation to stocks and bonds. New portfolio: 48% stocks + 32% bonds + 20% hedge funds.
Result: Expected returns rise to 6%, volatility drops to 8%, and Sharpe ratio increases to 0.75 (an improvement of 50%).
This is still just one fund. What if you can find two or three uncorrelated top funds? Now you understand why such assets are so precious.
Institutions rush to invest in top funds, not because they don't know index funds are cheap, but because they understand the mathematics at the portfolio level. What is being compared is not fees, but the portfolio efficiency gained from those fees.
How to select funds like an institution
Assuming you want to find products close to top-tier hedge funds, but cannot access Citadel/Millennium/Point72 and have plenty of time to research. How to filter?
Focus on these key points:
Look at long-term factor exposure: not just current but look at rolling data over several years. Truly factor-neutral funds should have exposures to market, industry, and style factors that remain close to zero. If market beta fluctuates around 0.3, that is factor timing—potentially useful but not the product you want to buy.
Stress test: In a bull market, everyone appears uncorrelated. You need to look at crisis periods: 2008, early 2020, 2022. If drawdowns are synchronous with the market, it is not truly neutral and hides beta exposure.
Look at long-term Sharpe: short-term high Sharpe may rely on luck, but maintaining high Sharpe in the long term is difficult to achieve by luck alone. Sharpe is essentially a statistical significance indicator of returns.
Abandon the idea of replication: factor ETFs can give you exposure to factors like value and momentum at a cost of 0.15%-0.5% per year. But these are not the same products. Factor ETFs are related to factors, while neutral funds are not related. This correlation structure is key. You need to look for actively managed products or alpha strategies.
Recognize scarcity
After completing the above research, you might find that the number of products that fully meet all criteria is zero!
To be serious, you might find close products, but they are unlikely to accommodate institutional capital size. For sovereign funds managing trillions, an investment of hundreds of millions is meaningless.
In the end, you will understand: Only a very few companies can maintain a Sharpe ratio above 2 at a scale of over 50 billion and across multiple cycles. This is extremely difficult. Having factor neutrality + large scale + long-term stability, all three together is extremely rare. This scarcity makes the premium reasonable for those who can invest in it.
Finally
Paying a premium of 50-100 times for top factor-neutral hedge funds is supported by solid portfolio mathematics, which critics often overlook. Institutional investors are not foolish; the real issue may be: too many funds charge top fees yet only provide expensive beta that can be bought for just 0.15% per year.
(Note: The fund report already reflects net returns after all fees, no need for additional deductions.)
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