Highly paid hedge fund managers have complained for years that it’s unfair to compare their performance with the broad stock market during prolonged bullish periods. Hedge funds are designed to mitigate risk, the argument goes, and so investors in them might sacrifice some gains as markets rise while waiting for hedge funds to prove themselves in more challenging times.
Those times would seem to have arrived.
So far this year, stock markets have delivered weak returns, bond markets have turned in negative performances, and everything is much more volatile — just the environment that many hedge funds say they’ve been waiting for.
That’s because most stock-investing hedge funds can bet against particular shares, rather than just making bullish bets like mutual funds, and thus can profit even in flat or down markets. And hedge funds that wager on things like bonds, currencies and the likelihood of corporate mergers boast that their performances are unconnected to the stock markets and can rise in bull and bear markets alike.
The results for the first six months are now in — and they shatter the myth of hedge funds thriving in turbulent markets.
Hedge funds, on average, underperformed the Standard & Poor’s 500-stock index yet again. An index of hedge fund performance, calculated by the research firm HFR, gained just 0.81 percent in the first half of 2018. That is less than half of the S. & P. 500’s 1.67 percent gain.
“Hedge funds simply do not do what they claim from a risk or return perspective,” said Yogesh Dewan, chief executive of Hassium Asset Management in London, which invests for wealthy families. Mr. Dewan said he’s been investing in hedge funds for more than 20 years. “They really have not lived up to expectations.”
How could hedge funds underperform even in a lackluster year like 2018?
Two kinds of hedge funds, in particular, dragged down the average performance: quantitative funds, which use complex trading algorithms, and long-short funds, which take both bullish and bearish positions in stocks.
Computer-driven quantitative funds, which were all the rage just two years ago, have lost more than 4 percent so far this year and were “the worst-performing category,” according to Ken Heinz, HFR’s president. Many computer-driven strategies rely on correctly reading market and economic trends, and the strong bull-market trend ended abruptly in February, sending many surprised quant-fund managers scrambling to rewrite their algorithms.
Other so-called macro strategy hedge funds, including those focused on commodities and currencies markets, were also weak.
Long-short funds, sometimes known as market-neutral funds, eked out gains of just 0.25 percent this year, well behind the S. & P. 500, suggesting that these fund managers were worse stock pickers than most people, even in a market with many declining stocks.
Sebastian Mallaby, author of “More Money Than God: Hedge Funds and the Making of a New Elite,” told me this week that he now questions one of the basic premises of his book, which was published in 2010. Then, he felt that hedge fund managers’ compensation — typically 2 percent of their assets under management and 20 percent of any gains — provided a strong financial incentive to “hustle more and work harder,” which should have led hedge fund managers to do better than traditional mutual fund managers. “It hasn’t,” Mr. Mallaby said.
One reason, he suggested, is that the 20 percent incentive fee has declined in importance as assets have grown so large. “Once you have so much money under management, that 2 percent fee alone makes you rich. You can make so much money just sitting on the assets that the incentive to find great returns is weakened. I know many people in hedge funds, and that’s their attitude.”
He pointed out that in the early days of hedge funds, there were no management fees — just a percentage of whatever money their funds earned. He said institutional investors should now insist that hedge funds reduce their management fees.
Despite what now amounts to nearly a decade of underperformance, money keeps pouring into hedge funds. Hedge fund assets stood at $3.2 trillion at the end of 2017 and hit a record at the end of March, according to Mr. Heinz of HFR.
That seems a paradox, but the longer the bull market continues — it’s the second-longest ever, and is closing in on the record — the more institutional investors worry that another bear market is imminent and that hedge funds might provide protection.
“No one is forecasting a bear market,” Mr. Heinz said, “but things can change quickly. Given all the trade and tariff issues, we’re in uncharted territory.”
Hedge fund marketers have shrewdly exploited those fears and the still-vivid memories of 2008’s market rout, which left many pension funds and endowments reeling. “It is fair to say the hedge-fund guys are very smart in the way they market the asset class,” Mr. Dewan said.
Hedge funds didn’t protect investors from losses in the last bear market, but they did fare better than the S. & P. 500. Hedge funds on average lost 18.3 percent in 2008. The S. & P. 500 dropped 38.5 percent.
Given the weak returns, hedge-fund marketers have largely abandoned their strategy of pitching themselves as “absolute return” investments that perform well in both strong and weak stock markets. Now, at a time of low and rising interest rates, they’re describing themselves as more attractive than fixed-income assets like bonds, which have traditionally provided a haven when investors thought stocks were overvalued. Bonds and bond funds also tend to have much lower fees.
Hedge funds this year have outperformed the S. & P.’s United States bond index, which has lost 1.17 percent. But virtually risk-free two-year Treasury notes are currently yielding 2.55 percent — more than what hedge funds, which are far from risk-free, are on track to generate this year.
In any event, comparing hedge funds with low-yielding bonds after years of promising much higher returns is just “moving the goal posts,” said Simon Lack, author of “The Hedge Fund Mirage.”
Of course, the weak average returns mask the fact that some hedge funds have done comparatively well. So far this year, so-called activist funds, whose managers take positions and call for board and management change, have gained 2.78 percent. Merger arbitrage funds, which bet on whether corporate deals will come to fruition, gained 2.63 percent. But nothing comes close to last year’s 21.14 percent gain in the S. & P. 500 (including reinvested dividends).
Mr. Heinz conceded that the average hedge fund’s return of 0.81 percent “isn’t exactly hitting it out of the park,” but it is still better than most European and Asian stock indexes as well as the Dow Jones industrial average, which has declined 1.81 percent.
Mr. Lack said he isn’t surprised that hedge funds keep attracting new money. Inertia is powerful, and the industry of hedge-fund boosters is loud. “I’ve yet to meet a public pension plan interested in paying a consulting fee for a critical analysis of their hedge-fund allocation,” he said.
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