If Hedge Funds Are Lagging, Why Do They Have So Much Money?

By now it’s no secret that equity hedge funds have had a horrible decade. The real surprise is that a record $955 billion was invested in those funds at the end of September 2018.

Which raises the obvious question: Why are so many investors still hanging around?

During the go-go 1990s and the boom years between the dot-com and housing bubbles in the 2000s, the pitch for hedge funds was simple and sexy: “Give us your money and we’ll make you rich!” Sure, the fees were absurdly high, but investors weren’t as fee conscious then as they are now, and in any event, they were making too much money to care.

Managers had good reason to be confident. In 1990, there was a scant $14 billion invested in equity hedge funds, so there were more opportunities for outsized returns than money chasing them. Hedge funds took full advantage, and the HFRI Equity Hedge Total Index returned 16.6 percent a year from 1991 to 2007, outpacing the S&P 500 Index by 5.2 percentage points, including dividends.

Investors piled in along the way, and by the end of 2007, assets in the strategy ballooned to $685 billion, far more than equity hedge funds could realistically manage if they wanted to continue outpacing the market. The 2008 financial crisis didn’t help, either. It whipsawed hedge funds, as it did many other investments, and managers struggled to regain their golden touch. But they weren’t keen on returning the money to investors and giving up their lucrative fees, so they did the next best thing: They pivoted from making money to not losing it.

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Pension Funds Should Think Twice About Alternatives

High-performing alternative investments are great if you can find them, but pension plans shouldn’t count on it.

The Pew Charitable Trusts recently published its latest report on the investment practices and performance of the 73 largest state public pension funds as of the 2016 fiscal year. The big development is that pension funds are moving their money from stocks to alternatives such as private assets and hedge funds. The average allocation to alternatives more than doubled to 26 percent in 2016 from 11 percent a decade earlier, with a roughly equal percentage leaving stocks.

In an accompanying blog post, Pew warned that the move to alternatives would result in more volatility and higher fees for pension funds. Writing for Bloomberg Opinion, investor Aaron Brown took the opposite view last week, arguing that alternatives dampen volatility and boost performance, even after accounting for fees.

Neither view is entirely right. And with an estimated $1 trillion in state and local public pension funds invested in alternatives, and the retirement of 19 million current and former state and local employees at stake, decision makers rushing into alternatives should be clear about what they’re buying.

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Hedge Fund Stars Crying Uncle Gives Industry Hope

The hedge fund industry is losing its star managers but gaining an opportunity to rebuild its battered reputation.

Bloomberg News reported last week that Jon Jacobson, investor and founder of Highfields Capital Management, is winding down his $12.1 billion hedge fund after two decades. As the article noted, he joins a growing list of elite managers who have left the industry or plan to, including Richard Perry, Eric Mindich, John Griffin, Neil Chriss and Leon Cooperman.    

In a letter announcing his decision, Jacobson bemoaned a “very treacherous investment environment.” That’s no exaggeration.  

A combination of lethal forces has hit hedge funds in recent years. One is a raging U.S. bull market. Jacobson’s fund has been flat since 2017, while the S&P 500 Index was up 35 percent over that time through September, including dividends.

Granted, an investment in hedge funds isn’t the same as buying the broad stock market. But as I noted recently, that doesn’t stop many U.S. investors from comparing every investment with the S&P 500. And by that yardstick, few investments measure up over the last decade. Foreign stocks, bonds, private equity, venture capital, real estate and, yes, hedge funds have all lagged.

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Welcome to the Alternative-Investment Party. You’re Late.

If you want to get rich, here’s one way to do it:

  1. Find an investment that few investors know about.
  2. Write a pitch book laying out why that investment is likely to work.
  3. Sell your idea to rich institutional investors.
  4. Charge absurd fees.
  5. Let everyone know that your investment made lots of money for lots of investors.
  6. When your investment becomes too crowded to produce outsized returns, sell it to unsuspecting individuals.

Steps one through five are a brief history of so-called alternative investments, such as hedge funds, private equity and real estate. And now, thanks to JPMorgan Chase & Co., step six is underway.

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Hedge Funds No Longer Need the Star System

Hedge funds’ brightest lights have fallen on hard times, but don’t shed a tear for the industry just yet.

The list of once-revered-now-humbled hedge fund managers is growing. Alan Fournier is shutting Pennant Capital Management after nearly two decades, acknowledging that “recent returns have been disappointing.” David Einhorn’s main hedge fund at Greenlight Capital was down 14 percent in the first quarter  after a decline of 4.1 percent annually from 2015 to 2017. Pershing Square Capital Management’s Bill Ackman calledhis recent returns “particularly unsatisfactory,” and investors apparently agree. Ackman’s assets under management shrank to $8.2 billion as of March from $18.3 billion in 2015.

Despite the travails of star managers, however, the hedge fund industry is doing fine. The HFRI Fund Weighted Composite Index returned 0.3 percent during the first quarter, compared with a negative 0.8 percent for the S&P 500 Index, including dividends.

Granted, hedge funds haven’t kept pace with the stock market in recent years, but they’ve fared better than many of the stars among them. The HFRI index has returned 4 percent annually from 2015 through March, compared with 10.2 percent for the S&P 500.

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Bitcoin Isn’t an Investment Until Buyers Sweat the Fees

If you want to know where cryptocurrencies are in their development, keep an eye on fees.

When a new “investment” comes along, investors are often too busy counting their anticipated bounty to care about cost. Shrewd purveyors predictably seize the opportunity to charge excessive fees. But reality inevitably falls short of investors’ expectations, and the focus eventually turns to how much they’re paying to invest.

That’s a short history of stock investing. Investors had little access to stock market data a century ago. They didn’t have the luxury of knowing, for example, that the S&P 500 Index would generate a real return of 7.1 percent annually from 1926 to 2017, including dividends. Or that the index’s real return would fall short of that long-term average 52 percent of the time over rolling 10-year periods.

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Ray Dalio’s Short-Bet Puzzle Is Missing Some Pieces

Hedge fund titan Ray Dalio is famously enigmatic, but his latest wager may be the most puzzling yet.

Bloomberg News reported on Thursday that the fund Dalio founded, Bridgewater Associates, has made a $22 billion bet that many of Europe’s biggest companies in the blue-chip Euro Stoxx 50 Index are poised to decline.

Bridgewater didn’t respond to Bloomberg’s request for comment, so Dalio’s motivation is not entirely clear. But according to Bloomberg News’ Brandon Kochkodin, Dalio “has a checklist to identify the best time to sell stocks: a strong economy, close to full employment and rising interest rates.”

It’s an old idea. Economic fortunes are reliably cyclical, even if no one can precisely predict the turns. Booms tend to be followed by busts, and vice versa, and stock prices often go along for the ride.

By that measure, it seems like a precarious time for U.S. stocks. The U.S.’s real GDP has grown for eight consecutive years, by 2.2 percent annually from 2010 to 2017. Unemployment has declined to 4.1 percent from 10 percent in late 2009. And the yield on the 10-year U.S. Treasury is up to 2.9 percent from 2.1 percent in September — an increase of nearly 40 percent.

The problem with Dalio’s checklist, however, is that stock prices take their cue from companies’ fundamentals, not the economy. Yes, companies’ collective fortunes often reflect those of the broader economy, but not always. And when the two diverge, the relationship between economic results and stock prices breaks down, too.

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Slumbering Bear Holds a Lot of Answers

It has been almost nine years since the last U.S. bear market, as defined by a 20 percent or more decline in the S&P 500 Index. That’s the second-longest stretch without one since 1928, according to Yardeni Research Inc. Only the period from December 1987 to March 2000 was longer.

That’s a long time for questions to pile up that can only be answered by the next downturn. Here are some of the most burning ones:

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For Hedge Funds, the Bear Can’t Come Too Soon

No one is more eager for the next bear market than long-short hedge funds.

Long-shorts had a good year in 2017. The HFRI Equity Hedge Total Index — an index of long-short equity hedge funds — returned 13.5 percent last year, its best performance since 2013.

But as my Bloomberg View colleague Barry Ritholtz pointed out last week, it wasn’t good enough. The equity hedge index trailed the S&P 500 Index by 8.4 percentage points last year, including dividends. It was the ninth consecutive year that long-short hedge funds trailed the broader market, and the S&P 500 outpaced the equity hedge index by a stunning 8.1 percentage points annually over that period.

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Hedge Funds Have a Performance Problem

Hedge funds have had a tough go of it lately. The HFRI Fund Weighted Composite Index – an equal-weighted index of hedge funds – was down 1.1 percent in 2015, and is down another 2.3 percent through February of this year.

It’s not just your workaday hedge funds that have stumbled – the supernovas are burning less brightly, too. Greenlight Capital was down 20 percent in 2015. Hedge funds at Citadel, Blackstone, and Millenium have seen declines this year. And, well, Bill Ackman and Pershing Square’s Valeant debacle.

Granted, every investment has its ups and downs, but investors who dismiss hedge funds’ recent woes as an ordinary cyclical downturn are missing the larger and more worrisome picture.

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