It has been a tough couple of years for the hedge fund industry.  The HFR Global Hedge Fund Index showed returns of -0.6% in 2014, -3.6% in 2015, and +0.8% through 8/31 of this year significantly underperforming the S&P 500 which returned +13.7%, +1.4%, and +7.8% during the same periods.  This was not a case of industry lightweights pulling down the average.  Well known funds such as Pershing Square, Glenview, Tiger Global, and Paulson have all reportedly struggled.  Investors who had been promised “equity like returns with less volatility” may have experienced the less volatility part, but are understandably frustrated with the returns.

One early response has been to decry the “outrageous” fees that hedge funds charge.  Fees are high and while I applaud efforts to reduce them, I still find this complaint somewhat curious.  While lower fees would have helped, they wouldn’t have closed the gap in performance.  I think part of the noise is a product of envy, as it is a sometimes awkward fact that hedge fund managers make a lot more money than the allocators who invest in them.  I would argue that hedge fund fees are lower than private equity or private real estate fees¹ while offering better liquidity, but the cacophony regarding hedge fund fees is much louder.  At the end of the day it is all about net (after fee) performance and as hedge funds have underperformed (as reported by the New York Times), several high profile investors such as CALPERS, AIG, MetLife, and NYC’s pension have greatly reduced or eliminated their exposure.

If it’s not all fees, what went wrong?

There are several candidates, but I will focus on three:

• The first is expectations.  It may not have been obvious ten years ago (at least not to me, Warren Buffet on the other hand made this bet), but “Equity like returns with less volatility” certainly seems unrealistically ambitious today.  However, less volatile, uncorrelated returns can still be a useful part of an investor’s portfolio.
• The second more obvious answer to what went wrong is security selection.  Managers simply picked the wrong stocks.  The best performing stocks recently have been high dividend paying.  Utilities for example are up almost 20% this year.  I wouldn’t expect hedge fund managers to buy utility stocks and clip dividends, so it doesn’t surprise me that they have underperformed in this environment.
• The third issue is size.  A recent academic article by Chengdong Yin of Purdue argues that the temptation for managers to grow beyond their optimal size has been too great to resist.  Many investors have decried the growth of the industry as one of the hindrances to performance, but research from Barclays indicates that it is not the size of the industry, but rather the size of the funds that is the problem.  This makes sense to me.  In order for big funds to make trades that move the needle for their performance, they need to make big investments and this reduces their investable universe.  The bigger the fund, the smaller the universe, the smaller the universe the harder it is to generate returns.  CALPERS has a similar problem.  It’s not worth their while to invest in smaller funds.  That, combined with disappointing performance by larger funds, makes it sensible for them to exit the space, but…

Does this mean it is the right time for everyone to leave all hedge funds?

It is common investment advice to encourage contrarian behavior – to buy when everyone else is selling – but the reality of investing is more complex.  The 10-year U.S. Treasury currently yields a measly 1.70%.  The S&P 500 is trading at the highest price to earnings multiple since 2009.  Given the current equity and fixed income markets, this could be exactly the wrong time to leave hedge funds.  Partly as a result of investor demands, and partly due to the increased number of funds competing for investors’ dollars, fees are starting to come down.  Smaller investors, who have both the ability to invest in smaller funds and the capability to identify high quality managers, may be well served to stay invested, but to rotate into less crowded strategies and more nimble funds.  These funds may bring uncorrelated returns to a portfolio in an environment just when those returns are needed most.  While it is certainly understandable for hedge fund investors to be fed-up with returns from more plain vanilla allocations, I continue to believe hedge funds, and alternative investments in general, represent an important asset class that can provide meaningful and differentiated returns over time.

¹ _{PE and RE fees are multilayered and complex and it is difficult to compare them with hedge fund fees.  In my opinion, PE and RE fees are higher in general, but there are certainly scenarios under which hedge fund fees would be higher.}