The past year provided mediocre returns for the hedge fund business. The HFRX, a measure of hedge fund industry returns, showed a gain of only 3% relative to the S&P 500 which returned 13.4%, according to Value Walk. A seasoned investor understands that judging performance by one year is not the wisest idea, though over the past ten years the S&P 500 has outperformed hedge funds as measured by the HFRX global index except for in 2008 when both metrics suffered greatly. In analyzing a simple-minded investment portfolio, with 60% in equity and 40% in sovereign bonds, the portfolio has brought returns of more than 90% over the last ten years compared with a return of only 17% for hedge funds after fees. Collectively, the supposed aggressively managed portfolio returned less than the rate of inflation over the past decade, according to the Economist.
However, I have been comparing average hedge funds returns. When looking individually, the top tenth of the hedge fund industry has provided returns of more than 30% in the past year, according to Hedge Fund Research. Reversely, a third of the industry has lost money including superstars of past years. For instance, John Paulson, celebrated for foreseeing the housing bubble, had his fund lose 17% in the first ten months of 2012 which followed a 51% loss in 2011. Hedge funds cite numerous reasons for poor performance including the heightened governmental influence on the stock market, specifically the central bank and the monetary policy. Hedge funds feel as though the central bank has heavily influenced market movements in the past few years and as such made analysis far more difficult.
This has ushered in a change of tone from the hedge fund industry. Where once hedge funds were seen as the dark horse of Wall Street, using leveraged, long, and short and derivative positions, they are now focusing more on long term stability of returns. This may be a wise tactical move though. A decade ago hedge funds catered to mainly high net worth individuals with institutional investors only making up 20% of the industry’s assets. Fast forward to 2013: institutional investors now make up over two thirds of the industry’s assets. These institutions, which include numerous pension funds and endowments, are far more risk averse than were the clients of the past decade. Leverage, which was used to magnify returns though also greatly increasing risk, is now at an all-time low. Another reason for lessened returns is that hedge funds now control $2.2 trillion in assets which is up fourfold from 2000. This is believed to have caused hedge funds to take second rate bets that would’ve been considered marginal in the past, according to the Economist.
Lastly, Exchange Traded Funds (ETFs) have opened up diversification to investors with fees that are only a few basis points. With ETFs, investors can invest in anything from land to gold to specific industries in the market without buying individual stocks for commodities. Compare this with a hedge fund that charges investors the traditional fee of 2% of assets and 20% of profits. Institutions have put pressure on the hedge funds to reduce these steep fees, though they have had limited success.
The silver bullet of the hedge fund industry is that a small percentage have provided incredible returns. However, the average hedge fund is a poor bet for most investors. Furthermore, predicting which hedge fund will provide those astronomical returns is much like trying to get through Mid-Town Manhattan during Rush Hour: impossible.
Citations:www.economist.com