19 October 2017

Hedge Funds Keep Winning Despite Losing

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Hedge funds are in a six-year slump. Financial markets have been rising but these highly paid investors can’t seem to keep up. It’s getting so bad, hedge funds are starting to draw comparisons to mutual funds, long criticized for poor performance relative to their fees. It’s a bit like saying Ferraris are starting to resemble Fords.

Those groans you hear are likely coming from Greenwich, Conn., hometown of many hedge funds. These managers correctly note that they’re paid to hedge, or protect, their clients’ portfolios, not make all-out market bets, so it’s unfair to compare them with broad stock indexes. Hedge funds tend to hold cash, short positions and other defensive holdings to cushion performance in a downturn.

Fund managers argue their balanced approach will bear fruit when the market hits its next rough patch. Also, because index funds buy and sell wide swaths of the market without differentiating among sectors and stocks, hedge-fund traders insist they will profit once the market ceases its headlong surge.

Here’s the problem: 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.  By contrast, the average hedge fund rose 3% last year, an annualized 6.97% a year since 2009 and 5.1% a year annualized over the past decade, according to HFR, a hedge-fund data tracker.

How to explain the paradox of a superhot investment vehicle producing ice-cold returns for clients more smitten than ever? Part of the reason for the lackluster returns: Hedge funds don’t have the same incentive to hit home runs they once did. They can charge management fees of close to 2% of assets. As the industry swells, many managers can get rich just keeping their funds afloat. A decent performance and no huge loss will do just fine.

The head of one of the world’s largest funds recently said his challenge is to get his traders to embrace more risk, not less. Hedge-fund traders are more conservative because it’s in their self-interest to be more conservative. There are similar ways to explain why hedge-fund clients aren’t up in arms. Some see an expensive market and want to be in a vehicle that should do better in a downturn. But others simply want to keep their jobs. Recommending low-cost balanced mutual funds can be hard to justify if one has a well-paid job at a big pension fund or endowment. Properly allocating money to hedge funds is seen as a bigger challenge. Investing in brand-name hedge funds instead of big stocks once might have put an institutional investor’s career on thin ice. Today, avoiding popular hedge funds to wager on the market is seen as a risky career move.

Once, hedge funds promised gains in any kind of market. Now that they’ve embraced a more conservative tack, they sometimes urge clients to compare their returns with those of low-return bonds, not stocks. By that measure, the funds are doing better. Bonds have scored annualized gains of 4.69% since the beginning of 2009.

Click here to access the full article on The Wall Street Journal. 

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