Shrink to fit

2 May 2016 By Richard Beales

Too many hedge funds don’t earn their keep. In the wake of feeble returns, the $3 trillion industry in the first quarter suffered its largest outflow of investor cash since 2009, according to Hedge Fund Research. It could be for the best. The high-fee model may be better suited for the periphery than the mainstream.

Warren Buffett was gleeful at the annual meeting of Berkshire Hathaway on Saturday. Eight years ago he bet the leading lights at the Protégé Partners fund of hedge funds that, over a decade, the S&P 500 Index of U.S. stocks would outperform five fund vehicles of their choice. With just two years to go, Buffett’s chosen Vanguard index fund is up 66 percent to the hedge funds’ 22 percent.

That underlines the recent inability of the average hedge fund to beat market returns after – and despite – hefty fees, which typically approach 2 percent a year on assets and 20 percent of investment gains. HFR’s broad indexes show that in recent years, average fund performance has lagged U.S. stocks, both overall and in almost all specific strategy classifications, for example event-driven funds.

The shift from the edges of markets to the center may be part of the problem. Back when Buffett ran a fund, and thereafter for big names like George Soros, it was possible to make smart, out-of-the-ordinary, illiquid bets without many people noticing.

Now there are many more hedge funds – more than four times the 2,000 or so that existed 20 years ago, by HFR’s count. That makes it more likely trades will be crowded and make less money. And a shift toward institutional rather than individual investors has led many funds to take less risky and more liquid bets lest they rattle pension-plan trustees and the like. Meanwhile, hedge funds’ earlier success has bred copycat rivals in cheaper mutual-fund packaging.

To be fair, in the crisis year of 2008 hedge funds on average lost a lot less than stock markets. And they aren’t all trying to beat stocks – though some individual strategies should still be winners, and lately these have been as rare as hens’ teeth.

Among the multitude there remain a few managers who consistently beat the market, and hedge funds still have fans. For many of the best, however, size is the enemy. And for most investors, it’s simpler and more profitable to buy index funds than to try to find the hedge fund winners.

 

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