The $2.5 trillion hedge-fund industry, whose money managers are among the finance world’s highest paid, is headed for its worst annual performance relative to U.S. stocks since at least 2005.
“It has been difficult for hedge funds on the short side,” said Nick Markola, head of research at Fieldpoint Private, a $3.5 billion Greenwich, Connecticut-based private bank and wealth-advisory firm. “Funds were defensively positioned. Central bank action did bode well for equities and made for a more challenging environment for hedge funds.”
Hedge funds, which stand to earn about $50 billion in management fees this year based on industrywide assets, are underperforming the benchmark U.S. index for the fifth year in a row as the Federal Reserve’s economic stimulus program pushes equity markets higher. Billionaire Stan Druckenmiller, who produced annual returns averaging 30 percent for more than two decades, last month called the industry’s results a “tragedy” and questioned why investors pay hedge-fund fees for annual gains closer to 8 percent.
“We were expected to make 20 percent a year in any market,” Druckenmiller, 60, said in a Bloomberg Television interview on Nov. 22, referring to veteran managers such as Michael Steinhardt, Julian Robertson, Paul Tudor Jones and George Soros. “If the market went down more than 20 percent, we were expected to make more.”
The industry traditionally charges clients fees of 2 percent of assets and 20 percent of profits, sometimes with discounts for big investors. Actively managed U.S. stock mutual funds average 1.3 percent expense ratios, according to Morningstar Inc. Such managers averaged gains of 31 percent this year through last month, Morningstar said.
Hedge funds posted a 0.2 percent gain in November, according to the Bloomberg Global Aggregate Hedge Fund Index. They’ve underperformed the S&P 500 by 97 percentage points since the end of 2008. Some managers cite government intervention in markets, record low interest rates, declining trading volumes and assets moving in unison as reasons for limiting their ability to outperform.
It is a tough world out there but has the hedge fund industry peaked? Yes, in my opinion, and I maintain that it peaked near the beginning of this century.
Hedge funds charge the highest fees in the money management industry. To justify those fees, the managers need to be either very smart in terms of asset selection and timing, or lucky in terms of riding a mostly consistent long-term uptrend trend. It is not surprising that the heyday for hedge fund managers occurred during the last secular bull market of the 1980s and 1990s, and they were feted like pop stars.
Most hedge fund managers use leverage, which can be very rewarding in sharp or persistent moves. However, leverage is inevitably a double-edged sword. It also has a siren call, as anyone who uses leverage knows. If using two or three times leverage proved to be a good idea, why not leverage up ten times, or really roll the dice at a hundred times when you have the next ‘sure winner’? That is exactly what the misnamed Long-Term Capital Management did in 1998, and nearly triggered a global financial crisis before being bailed out by the Federal Reserve.
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