The Golden Age of Hedge Funds

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“There are about 8,000 planes in the air and 100 really good pilots.”

A quantity of years in the past, Ray Dalio of Bridgewater Associates was requested what number of hedge funds are price investing in. That quote was his response.

And Dalio ought to know. One of the all-time nice hedge funds, Bridgewater manages round $150 billion for a lot of of the most important institutional traders on this planet.

Echoing Dalio’s sentiments, Matthew Granade, chief market intelligence officer for hedge fund legend Steve Cohen, told the London School of Economics:

“Hedge funds are struggling to meet their promise to clients to consistently produce high returns with low correlation to the markets. It’s kind of: ‘I promise you a Rolls Royce and I give you a Honda.’”

It’s telling that some of the largest and most profitable hedge fund managers within the enterprise are questioning their friends.

The downside is that a big quantity of traders are having a tough time allocating their property. Why? Because US rates of interest are far beneath common whereas US inventory market valuations are far above common. So traders flip to hedge funds of their seek for an choice someplace between shares and bonds that may assist them to attain their objectives and hit their return targets.

The query is: How many of the hundreds of hedge funds on the market are literally price investing in?

Let’s check out the historic observe report of the business to see how the recognition of this fund construction has affected efficiency. The chart beneath reveals the returns for the HFRX Global Hedge Fund Index from its inception within the late 1990s in comparison with US shares, US bonds, international shares, and a easy 60/40 portfolio over three totally different time frames.


Annual Hedge Fund Returns


Since 1998, returns have been pretty related throughout every asset class or technique.

Considering the elevated inventory market valuations from the start line on the tail finish of the tech bubble, it isn’t shocking that inventory, bond, and hedge fund returns haven’t diverged a lot from each other within the years that adopted.

After the tech bubble and its subsequent bust within the early 2000s, hedge funds enjoyed a run of extraordinary efficiency. And with inventory markets across the globe falling greater than 50% in some instances, massive institutional traders took discover.

Pensions, endowments, foundations, and sovereign wealth funds showered hedge funds with money in hopes that their success would proceed. This brought on an enormous growth within the complete quantity of hedge funds and the property they managed.

In 1998, there have been round 3,200 hedge funds with roughly $210 billion in assets under management, based on estimates. Today, there are northwards of 11,000 hedge funds with property totaling over $3 trillion. Size is the enemy of outperformance, and hedge funds are an ideal instance of this.

Look at how effectively complete hedge funds did within the 1998 to 2003 interval after which have a look at how they’ve carried out since.

Clearly, the majority of the returns got here in the course of the superb five-year interval spanning the lead as much as and aftermath of the tech bubble.

The correlation to the general inventory market was comparatively low in the course of the salad days of hedge funds within the early 2000s, however that relationship has since utterly modified. During the monetary disaster, hedge funds didn’t maintain up almost in addition to they did in the course of the tech crash.

And they’re extra correlated to the inventory market now than ever earlier than, though they’ve entry to a a lot wider selection of funding methods.


Correlation of HFRX Global Hedge Fund Index with the S&P 500
Rolling 36 Months: 1998–2016

Correlation of HFRX Global Hedge Fund Index with the S&P 500 Rolling 36 Months: 1998–2016


The inflow of institutional capital into the area could clarify a lot of this modification. Hedge funds as soon as operated on the fringes of the asset administration business and so might tackle extra danger. Now that they need to accommodate massive institutional traders with strict due diligence and funding pointers, they’ll’t tackle the identical dangers. Instead, they’re giving traders what they ask for — decrease volatility. And decrease volatility means decrease returns.

Besides the expansion within the quantity of funds, one thing else modified within the hedge fund area. Regulation Fair Disclosure (Reg FD) got here into impact in 2000. This SEC-mandated rule pressured all publicly traded firms to reveal materials data to all traders on the similar time. Prior to this, hedge funds had an enormous benefit in phrases of the data they may get hold of previous to different traders. Reg FD modified that. This, mixed with the massive quantity of funds chasing related securities and utilizing related methods, has resulted in a lot decrease efficiency for traders.

Now to return to the authentic query: If the common efficiency of hedge funds leaves a lot to be desired, what number of are price investing in?

Very few — a minimum of based on Cambridge Associates, a big institutional funding consulting firm that recommends hedge fund investments. Just 2% — or round 250 — of the 11,000-plus hedge funds can efficiently produce returns ok to account for the excessive charges and competitors.

Cambridge recommends paying excessive charges just for these funds producing constant alpha. That is usually a tall order when solely 2% of funds match this invoice and when previous efficiency isn’t any assure of future outcomes.

All of the brand new cash that rushed into hedge funds created extra competitors for alpha. When hedge funds had been smaller and nimbler, there was sufficient outperformance to go round. Now there are such a lot of funds, algorithms, PhDs, mathematicians, pc scientists, and MBAs competing for items of a a lot smaller alpha pie. When you add in the exorbitant fees, what you get is worse performance.

And that’s precisely what most hedge fund traders have obtained.

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All posts are the opinion of the creator. As such, they shouldn’t be construed as funding recommendation, nor do the opinions expressed essentially mirror the views of CFA Institute or the creator’s employer.

Image credit score: ©Getty Images/thedafkish

Ben Carlson, CFA

Ben Carlson, CFA, is on the portfolio administration staff for an endowment fund in Grand Rapids, Michigan. Carlson has been working in institutional portfolio administration for over a decade.

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