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Rotten alternatives 

13 May 2014 By Martin Hutchinson

Hedge fund customers’ yachts are washing further away. The flood of money – now $2.7 trillion – in hedge funds has squashed returns below public stock markets. Private equity doesn’t seem to be doing much better. Investors beware.

Big-name hedge fund managers, some of whom will be in Las Vegas this week at the 1,800-strong SkyBridge Alternatives SALT conference, are doing fine. Four industry titans collected over $1 billion in personal gains and fees in 2013, according to Institutional Investor’s Alpha, and the top 25 collected a staggering $21.2 billion between them. That was up 50 percent from 2012, though below the peak of 2009.

Their investors are not so flush. The S&P 500 Index yielded 32 percent including reinvested dividends last year, while the average hedge fund brought a net return of only 9.1 percent for investors, according to Hedge Fund Research. Hedge funds are prone to underperform stocks in a bonanza year for equities, but HFR’s index hasn’t shown a return above 20 percent in the last decade. Recalling the title of Fred Schwed’s 1940 investing classic, that’s not going to buy a lot of customers’ yachts.

One reason for hedge funds’ pallid performance may be their size. Total assets in the sector have nearly tripled from $973 billion a decade ago. By definition, arbitrage opportunities are finite, and although markets are growing they are also becoming more transparent. A glut of capital chasing opportunities will tend to reduce the potential returns.

Private equity funds are enjoying the same flood of cash, with a record $1.1 trillion in “dry powder” awaiting investment as of March, according to Preqin. With buoyant equity markets and prolonged low interest rates, market conditions have been favorable for years. Yet overall returns are only beating the public equity market by 2.7 percentage points, according to a National Bureau of Economic Research paper in November. That’s only just enough to compensate for the sector’s risk and illiquidity, the researchers reckon.

The huge influx of cash bodes ill for future private equity and hedge fund performance. There’s also the risk that healthy management fees encourage fund bosses to gather assets even as their ability to find good investments dwindles. The promise of better or uncorrelated returns has led institutional investors to divert more and more funds to non-traditional categories. Maybe they should be on the lookout for alternative alternatives.



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