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.
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