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.
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.
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.
The U.S. stock market is dominating again this year, and money managers may soon face some unpalatable choices.
It’s not even close. The S&P 500 Index is up 9.9 percent in the eight months through August, including dividends. Meanwhile, overseas stocks, as measuredby the MSCI ACWI ex-USA Index, are down 3.2 percent. U.S. bonds, as represented by the Bloomberg Barclays U.S. Aggregate Bond Index, are down 1 percent. And hedge funds, as tracked by the HFRI Fund Weighted Composite Index, are up a modest 1.7 percent.
It’s too soon to know how private assets, such as venture capital, private equity and real estate, have done because their results are generally reported on a multi-month lag. But it’s not likely to matter. Even the most ardent admirers of private assets, such as elite university endowments, allocate only a portion of their portfolios to them. So the results, however good, are unlikely to make up for the drag from other assets.
Lots of people want to invest like elite university endowments, but securities laws don’t allow it. It’s time to remove those barriers.
But it’s worth asking whether investors should aspire to the so-called endowment model in the first place. According to numbers compiled by the National Association of College and University Business Officers, universities with the biggest endowments generated an average return of 9.7 percent annually over the last 30 years through June 2017 — the longest period for which annual returns are available — slightly edging out the S&P 500 Index’s return of 9.6 percent, including dividends.
Admirers of the endowment model are quick to point out that it’s less volatile than the stock market. The better comparison, they say, is a traditional 60/40 portfolio of stocks and bonds. That mix, as represented by the S&P 500 and the Bloomberg Barclays U.S. Aggregate Bond Index, returned just 8.6 percent over those three decades, or 1.1 percentage points a year less than endowments.
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.
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.