Are Hedge Funds Dead?

adam_woodsWhat Is A Hedge Fund?

In the simplest sense, a hedge fund is a firm that invests capital for its investors. Typically, hedge fund clients are institutional investors (anyone who is charge of allocating a large pool of capital) or accredited investors (e.g. high net worth individuals).The traditional definition is that hedge funds are able to place both long and short positions – (e.g. make money in both up and down markets). The vast majority of the portfolio managers are long only – meaning they only make money when markets go up. Therefore, by definition, hedge funds are considered alternative investments and are different than a typical long only strategy.

Should you invest in one…?

Why Invest In Hedge Funds?

The short answer is for better returns. The unique value proposition from the hedge fund industry is that they are able to attract the best talent (superior managers with very strong track records) and offer their investors superior risk-adjusted returns. In exchange for this “privilege” hedge funds charge higher fees than most other investment vehicles and if they do not perform well the large fees hurt their performance. In some cases, when the hedge fund puts up solid numbers the fees are justified. The only problem is that there is no way to know for sure which hedge fund will be able to put up solid returns at any given year. Before 2008, most hedge funds were charging 2% and 20% – that is a 2% management fees on the assets under management and 20% incentive fee on any profits they produced. After 2008, returns are harder to come by so most hedge funds now charge 1 & 20. For example if a hedge fund has $100 million under management they would get a base fee of $1 million and then 20% of any profits they generated. If the fund was up 10% that year- they would get an additional $2M incentive fee. So the total income for that year in this example would be $3M. As you can see that is a very lucrative business and a strong reason why some of the most talented people on Wall Street move in that direction.

The Problem – Post 2008- The World Has Changed; Hedge Funds Are Not Performing Well

Since the 2008 financial crisis, the world has changed in many ways. From an investing point of view, hands down the strongest asset class in the world has been the stock market. In fact, the returns are so strong (largely due to easy money policies from global central banks) that other asset classes (currencies, bonds, and commodities) have been left behind as nearly all capital continues to flow into stocks. As a result, the average hedge fund has been underperfomring the largest benchmark in the world- the S&P 500. Remember, if the hedge fund manager has a real problem if she is not able to beat the S&P 500. The primary reason why hedge funds charge high fees is because of their ability to beat the market. Therefore, the fact that most hedge funds are struggling to put up strong returns is causing investors to re-think their allocation to this space. According to the Barclay Hedge Fund Index, hedge funds overall returned only 11% in 2013, while the S&P 500 soared 30%. In 2014, they are only up 4.5%, which pales in comparison to the S&P 500’s nearly 8% advance. Eventually, the environment will change and the stock market will not go straight up. But until it does, hedge funds face a real problem.

Hedge Funds Are Losing Clients:

The California Public Employees’ Retirement System’s (better known as Calpers) announced this week that they are going to stop investing in hedge funds. The largest pension fund in the country currently manages $330B and only had $4B in hedge funds. The fact that they are pulling their investment for now will likely hurt the stagnate hedge fund industry as more investors will likely follow their lead and pull their money from under-performing hedge funds. Last year Calpers only earned 7.1% paid over $135 million in hedge fund fees. Remember, that the S&P 500 returned 30% so that return does not justify they high fees that were charged. Everything runs in cycles and this just happens to be a low point for the hedge fund business. Down the road when the stock market turns lower, or other asset classes start performing well again, the alternative investment space will likely shine.

Trade wisely,

Adam Woods

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