Are the Glory Days of Hedge Funds Behind Us?

Hedge funds have become a cornerstone of institutional investment portfolios, growing from around $200 billion in assets under management at the turn of the millennium to nearly $6 trillion today. However, this growth has brought increasing scrutiny, with investors and critics questioning whether these strategies still deliver the elusive “alpha” — excess returns above a comparable market portfolio — and provide the downside protection that once set them apart from traditional portfolios of stocks and bonds.

Today’s hedge fund industry stands at a crossroads. Nearly three decades of hedge fund performance reveals a profound transformation in how hedge funds deliver (or fail to deliver) excess risk-adjusted returns — especially since the 2008-09 Global Financial Crisis (GFC).

Pre-GFC: A Period of Robust Alpha

Before the GFC, hedge funds as a group provided meaningful outperformance after properly accounting for traditional stock and bond market risks. From January 1994 through December 2008, the average hedge fund delivered risk-adjusted alpha of about 3.7% per year net of fees.

This was no trivial accomplishment. When measured against a traditional portfolio of equities and bonds with comparable risk, hedge funds seemed to offer a genuine edge, both in performance and diversification. Investors benefited not only from higher excess returns but also from downside protection during episodes such as the early 2000s tech bust and the GFC.

This strong pre-GFC alpha was also evident within equity-focused hedge funds — a major segment of the hedge fund universe. Equity hedge fund managers capitalized on market inefficiencies, style factors and skillful security selection, achieving annualized alphas that often ranged above 4%. Their approach typically combined equity exposures with smaller, growth-oriented, and higher-momentum stocks, alongside certain non-traditional risk factors. Back then, it seemed hedge funds could reliably add value beyond what traditional market exposures could explain.

Post-GFC: A Dramatic Shift in Performance

The environment for hedge funds changed markedly after the GFC, however. From January 2009 through December 2022, the average hedge fund’s market-adjusted alpha turned slightly negative after fees and expenses, declining from about +3.7% annually before the crisis to near zero afterward. This shift means that hedge funds as a group, on average, have failed to outperform a properly risk-adjusted portfolio of stocks and bonds in the post-GFC era.

The subset of equity hedge funds likewise witnessed a downturn in performance adjusted for traditional stock and bond market exposures. Once able to deliver meaningful excess returns, these managers found that their previous formula for success no longer produced the same results.

After 2009, some strategies became less effective.  For example, the momentum factor (buying, or going long, winning stocks and selling, or shorting, the losers) generated less reliable returns. Also, managers continued to favor “junkier,” or lower-quality, stocks which hurt performance across both periods. As a result, equity hedge funds’ alpha also shrank to near zero after adjusting for market risk.

Explaining the Decline: Factors, Style Exposures, Active Risk

Much of the “secret sauce” that fueled hedge fund alpha in earlier decades has seemingly faded away. This may be because previously rewarded tilts — strategic shifts toward certain types of investments — became well known and widely implemented and thus no longer offer the excess returns as seen in the early 2000s — a case of too much money chasing  too few ideas. In fact, equity and bond market exposure alone is able to explain over 80% of the variation in returns post-GFC, up from around 60% in the earlier period.

Using a multi-factor model that included not only traditional market risks (stocks and bonds) but also widely recognized style factors — such as value, size, momentum and quality — accounted for nearly 90% of the variation in equity hedge fund returns after the GFC.

What’s more, the post-GFC environment shows that hedge funds have materially altered their approach. As a group, equity hedge fund managers significantly reduced their active risk-taking, which, in turn, contributed to lower alpha.

Perhaps facing more efficient markets, heightened competition and greater awareness of the same factors they once exploited, these managers found fewer opportunities for unique risk-taking and outperformance. In some cases, hedge funds reduced certain exposures — such as their tilt toward momentum stocks — that have tended to add value.

Global Macro and Managed Futures: Parallel Findings

Reported declines in alpha aren’t limited to broad hedge funds and equity-focused managers. Our most recent research on global macro (GM) and trend-following or managed futures (MF) strategies — often heralded as top-down investment strategies —reveals a similar pattern. GM and MF funds, once known for producing positive alpha and helping dampen portfolio drawdowns during turbulent periods, have seen their value proposition erode in the post-GFC era as well. Although global macro managers still tend to provide somewhat better downside protection than managed futures managers, both categories have found it harder to outpace a comparable risk-adjusted stock-bond portfolio.

Implications for Investors and Policymakers

The era of repeatable alpha and robust downside protection seems to have disappeared in the past decade. What remains is a more nuanced landscape where careful analysis and scrutiny of active risk-taking determine whether managers truly earn their place within investor portfolios. Paying hedge fund fees for diminishing excess returns may make less sense today than it did two decades ago. Successful investing in hedge funds requires insight into whether hedge funds are genuinely delivering skill-based alpha.

A More Nuanced Future for Hedge Funds

The data do not necessarily spell a sunset for hedge funds. Some managers have continued to innovate, uncovering new sources of alpha or navigating market environments more deftly than their peers.

Our research indicates that some hedge funds may still offer excess returns and serve as useful portfolio stabilizers in times of severe turbulence — though perhaps not as dramatically as before. But the era of robust alpha for hedge funds as a group appears to have passed. The hedge fund industry now operates in a world where excess returns are more difficult to generate.

Investors could benefit from setting more realistic expectations and considering what might constitute fair fees for the value being offered. In doing so, they may find that while hedge funds remain a part of the investment toolkit, their role — and the justification for their high fees — should be re-examined in the post-GFC landscape.

Rodney Sullivan is author of “Hedge Fund Alpha: Cycle or Sunset?” and “Hedge Fund Alpha: What about Drawdowns?,” published in the Journal of Alternative Investments, and co-author with Matthew Wey of the forthcoming article “Managed Futures Hedge Fund Strategies: Portfolio Differentiators?”