Most Hedge Funds Struggle Down in the Depths

November 29, 2012   Stephen Taub

Might some hedge fund investors soon turn to their brother-in-law’s broker? Or a dirt cheap index fund? According to a study drawn up by Hedge Fund Research, Inc. for Alpha, fewer than 11 percent of all hedge funds managers beat the S&P 500 in the first three quarters of this year.

In 2011 the group lost an average 5 percent while the indices eked out small gains. On average hedge fund managers have lagged the S&P 500 since 2009. For the three years ended September 30, 2012, just 12.5 percent of all hedge funds outperformed that benchmark.

Hedge funds last trounced the S&P in the dark days of the financial crisis. In 2008 they lost "only" an average 19 percent, vs. a 37 percent drop for the S&P 500. That year 83.5 percent of all hedge funds beat the market.

That’s nothing to sneeze at, of course. But hedge fund performance numbers in 2008 were boosted by systematic managers—investors who use computers to latch on to trends in a wide variety of markets—and macro traders, which are similar to systematic traders except real humans make the trading decisions—as well as short bias funds that specialize in betting on stocks they think will go down in price.

Since then, however, these three groups of funds have fared poorly.

The short bias funds have lost money in three of the four subsequent years amid a global bull market.

The systematic and macro funds have lagged the performance of the average hedge fund in each of the subsequent four years and have lost money for each of the two past years, including 2012.

Why have hedge funds consistently underperformed the market for the past four years and rarely beaten the averages in the past decade?

For one thing, as hedge funds—or any investment pool—grow larger in size, they become less nimble. Managers with single-focus strategies might need to expand to markets in which they are not as comfortable.

Also, as hedge fund managers become more successful, they personally own a larger share of fund assets. This often makes them more conservative, as preservation of capital becomes more important than swinging for the fences to win a slightly better return.

In addition, as more managers grow their firms and pull in more assets, they are claiming a bigger share of profits from the management fee. For many of these firms, asset gathering and growth have become more important than they once were.

In fact, last year 11 of the 25 highest earning hedge fund managers on Alpha’s annual rich list qualified for the ranking largely because of their hefty management fees. As a group they posted investment gains in the single-digit range.

Superstar hedge fund managers are a rare breed. The industry’s little secret is that perhaps two dozen hedge funds managers deserve fat two-and-twenty fees and a commitment for the long term. That’s it.

Ease of entry, lure of potential big paydays and light regulation have attracted hordes of new managers in recent years, especially after Wall Street retrenched in the wake of the financial crisis.

According to HFR, 1,757 hedge funds were open for business at the end of the third quarter, up about 30 percent from the end of 2008 and up 60 percent since the end of 2002. Over the past 10 years just half of all hedge funds beat the S&P 500.

The other half of the funds’ sophisticated investors weren’t so sophisticated after all.

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