How Many Hedge Funds Will Die Next Year?

(Answer: A Ton)

by John Rubino on August 24, 2015

For those who keep hearing about hedge funds but aren’t quite sure what they are: Think mutual fund with no rules. A hedge fund is an investment company that can do pretty much anything, from shorting currencies to betting on biotech takeovers to writing credit default swaps.

This kind of freedom, as you can imagine, requires a fair degree of creativity, if not genius, on the part of fund managers. And therein lies the problem. As the concept has gotten popular the number of hedge funds and the money they manage have soared. There are now 11,000 of them running about $3 trillion.

But have we produced 6,000 new super-genius money managers to handle all the extra money? Of course not. As in any other field, the sudden popularity of a concept just sucks in mediocre people from other niches. The result: Massive amounts of hedge fund money chasing pretty much everything, with an emphasis on what went up last year. The momentum trades are insanely crowded, and hedge fund returns in the aggregate have failed to exceed those of, say, an S&P 500 ETF for the past six years.

Yet the money has kept coming:

The Most Fascinating Investing Paradox

(Bloomberg) – Earlier this week, Greg Zuckerman of the Wall Street Journal pointed out one of the great mysteries of today’s investment landscape: Despite underperforming by a substantial margin, hedge funds keep attracting more investors and assets under management. It is almost as if (to borrow the headline on Zuckerman’s article), “Hedge Funds Keep Winning Despite Losing.” He wrote:

Hedge funds aren’t just underperforming against the S&P 500 and other stock indexes. They’re also losing out to low-cost “balanced” mutual funds that hold a mix of stocks and more-conservative investments, just like many hedge funds, suggesting their poor performance can’t be blamed on a hedged approach.

Consider the data: According to HFR, a firm that created indexes to track hedge-fund performance, the average hedge fund gained a mere 3 percent in 2014 versus an 11 percent rise in the Standard & Poor’s 500 Index. That’s hardly worth paying a hedge fund outsized 2 percent management fees plus a 20 percent cut of the profits.

Simon Lack, in his book “Hedge Fund Mirage,” describes why indexes such as those developed by HFR significantly overstate returns. That 3 percent gain last year, or about 7 percent annually since 2009, likely excludes funds that underperform. Funds don’t have any obligation to report their performance — it’s strictly voluntary. What we see in these indexes is an absence of poor performers that, were they included, might give a more accurate picture of the industry’s results. And that’s before we get to the issue of survivorship bias — funds that have gone belly up and closed due to their dismal results are missing from the index as well.

Perhaps you believe that the S&P 500 is an inappropriate benchmark. Consider a simple 60/40 portfolio of stocks and bonds. According to research from the Vanguard Group, that simple portfolio beat the returns of not only the hedge-fund industry as a whole, but almost all of the individual funds except for the outlying performance stars. And this 60/40 portfolio did it while charging fees of just 0.24 percent. The balanced fund beat the main Bloomberg hedge-fund index in six of the last seven calendar years, according to data compiled by Bloomberg. No wonder there is so much angst in Greenwich, Connecticut, home to many hedge funds.

This would be nothing more than an interesting bit of trivia if not for the fact that so many hedge funds use leverage. That is, they borrow money and toss it at whatever they’re chasing in order to magnify their returns. So when it doesn’t work they lose far more than they would have otherwise.

And now, with everything from energy junk bonds to emerging market currencies to blue chip equities imploding, the carnage in the hedge fund space can’t help but be epic. The question is how systemically dangerous the death of, say 5,000 of these funds will be. To which the likely answer is: Extremely.