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 are actually making a conceptual error. Saying hedge funds “underperform the market” is like comparing a boat’s speed to a car’s and then complaining that the boat is slow on the highway—completely missing the point.
The annual cost of buying the S&P 500 index (i.e., the market factor) is about 0.09%. Top hedge funds charge annual fees of 5%-8% (2/20 fee structure plus various expenses). The cost difference is 50-80 times.
If both offered the same thing, investors would be fools. But they offer different things, and institutional investors pouring in hundreds of billions are not fools.
What they buy cannot be replicated with money: factor neutrality, high Sharpe ratio, large-scale uncorrelated return sources. Once you understand this, the high fees make sense, and you won’t compare hedge funds to index funds anymore.
Where Does the Demand Come From
A common criticism is: “The S&P rose 17% this year, but Citadel only made 9.3%.” For most hedge funds, this criticism might hold, as many are just repackaged market volatility.
But this completely misunderstands the product logic of top funds like Citadel/Millennium/Point72. Their goal is not to beat the market; that was never their task. Comparing a fund designed for zero correlation to a 100% equity benchmark is like blaming an insurance policy for not making money—it makes no sense.
When you manage a trillion-dollar pension fund, with $60 billion already in stocks, you don’t lack equity exposure; you have too much. What you really need is something that rises when the stock market falls (or at least doesn’t fall with it). You need risk diversification. More precisely, you want something that rises regardless of market conditions and outperforms cash.
Sounds great, right? Feels like it would be expensive? Exactly! True risk diversification is extremely expensive because it is extremely scarce!
Who Are the Competitors
The long-term Sharpe ratio of the S&P 500 is about 0.35-0.5, meaning for every 1% volatility, you get 0.35%-0.5% excess return. Top global hedge funds have Sharpe ratios of 1.5-2.5 or even higher.
We’re talking about maintaining a Sharpe ratio around 2 for decades, not only achieving returns uncorrelated with market volatility but also with much lower volatility. These firms have small drawdowns and quick recoveries.
Hedge funds are not an expensive version of the same product; they are a completely different category. Top hedge funds offer two advantages that ETFs/index products do not:
· Factor neutrality
· High Sharpe ratio
Why Factor Neutrality Is Valuable
To understand the value of factor neutrality, look at this formula:
Return = Alpha + Beta × Factor Return + Random Error
· Alpha = Return from skill
· Beta = Exposure to systematic factors
· Factor Return = Return of market factors
· Random Error = Individual differences
The Beta part can be replicated with public factor portfolios. What can be replicated should only cost replication fees. Replication is cheap: 0.03%-0.09% for market factors, 0.15%-0.3% for style factors.
Alpha is what remains after subtracting all replicable parts. By definition, it cannot be synthesized through factor exposure. This irreplicability is the basis for the premium.
Key insight: Beta is cheap because factor returns are public goods with unlimited capacity. If the market rises 10%, all holders gain 10%; there is no exclusivity. S&P returns don’t diminish just because more people buy.
Alpha is expensive because it is a zero-sum game with limited capacity. For every $1 of Alpha earned, someone loses $1. The market inefficiencies generating Alpha are limited and disappear as capital flows in. A strategy with a Sharpe ratio of 2 at $100 million might drop to 0.8 at $10 billion because large-scale trading itself affects prices.
Factor neutrality (Beta≈0 for all systematic exposures) is the only truly irreplicable return source. This is why the premium is justified—not for the return itself, but for the inability to obtain such returns otherwise.
The Magic of High Sharpe Ratio
The compounding effect of high Sharpe becomes evident over time. Two portfolios with the same expected return of 7% but different volatilities (16% vs. 10%) yield vastly different results after 20 years. The low-volatility portfolio halves the probability of loss and offers much better downside protection.
For institutions needing stable payouts, this reliability is worth paying for.
Volatility not only affects the investment experience but also mathematically erodes long-term returns:
Geometric Mean Return ≈ Arithmetic Mean Return – (Volatility²/2)
This is called “volatility drag.” High-volatility portfolios inevitably underperform low-volatility ones over the long term, even with the same expected return.
The low-volatility portfolio ends up earning $48 million more, increasing wealth by 16%, despite having the same “expected return.” This isn’t about risk preference; it’s a mathematical fact: volatility erodes wealth over time.
Think Like a Professional Investor
Why are institutions willing to pay a 100x premium for factor-neutral funds? Look at portfolio mathematics.
Assume a standard portfolio: 60% stocks + 40% bonds. Expected return 5%, volatility 10%, Sharpe 0.5. Not bad, but stock risk is high.
Add 20% factor-neutral hedge fund: expected return 10%, volatility 5%, Sharpe 2.0, zero correlation with stocks/bonds. New portfolio: 48% stocks + 32% bonds + 20% hedge fund.
Result: Expected return rises to 6%, volatility drops to 8%, Sharpe rises to 0.75 (a 50% improvement).
And that’s just one fund. What if you could find 2 or 3 uncorrelated top funds? Now you see 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 portfolio-level mathematics. They compare not fees but the portfolio efficiency gained from those fees.
How to Select Funds Like an Institution
Suppose you want something close to a top hedge fund but can’t access Citadel/Millennium/Point72, yet have plenty of time to research. How to screen?
Focus on these points:
Look at long-term factor exposure: Not just current, but rolling data over several years. Truly factor-neutral funds should have exposure to market, sector, and style factors consistently near zero. If market Beta fluctuates around 0.3, that’s factor timing—maybe useful, but not the product you’re buying.
Stress test: Anyone looks uncorrelated in a bull market. Check crisis periods: 2008, early 2020, 2022. If drawdowns sync with the market, it’s not truly neutral; hidden Beta exposure exists.
Look at long-term Sharpe: High Sharpe in the short term might be luck; maintaining high Sharpe long-term is hard to attribute to luck. Sharpe is essentially a statistical significance measure of returns.
Abandon replication ideas: Factor ETFs give you exposure to value, momentum, etc., at 0.15%-0.5% annual cost. But this isn’t the same product. Factor ETFs correlate with factors; neutral funds do not. This correlation structure is key. You need actively managed products or Alpha strategies.
Recognize Scarcity
After the above research, you might find: The number of products meeting all criteria is zero!
Seriously, you might find something close, but it likely can’t handle institutional-scale capital. For a sovereign fund managing trillions, a few hundred million investment is meaningless.
Eventually, you’ll realize: Very few companies can maintain a Sharpe ratio above 2 at over $50 billion scale across multiple cycles. It’s extremely difficult. Factor neutrality + large scale + long-term stability—having all three is exceedingly rare. This scarcity makes the premium reasonable for those who can invest.
Conclusion
Paying a 50-100x premium for top factor-neutral hedge funds has solid portfolio mathematics behind it, which critics overlook. Institutional investors aren’t fools; the real issue might be: Too many funds charge top fees but only offer expensive Beta that costs 0.15% annually.
(Note: Fund reports already show net returns after all fees; no need for additional deductions.)
