Hardly a day goes by that the financial press fails to report the poor absolute performance or the actual winding down of one or more hedge funds, usually managed by some recently minted billionaire. Out of respect for some who are among our friends, we will refrain from naming names. The fact is that the heyday of high double digit returns that were enabled by leverage during the market's run-up to the financial crisis of 2008 is long since over. The broad market averages are no longer rising at a 20%+ pace. Concentration and leverage are no longer driving exceptional returns. Moreover, a great number of fund managers have been skeptical of the economic and stock market recovery since the crisis. As a result many have remained underinvested, or worse yet, have hung onto losing short side positions. Moreover, as the bull market has advanced and matured there are fewer and fewer undervalued asset classes or individual equities. As a result more and more leveraged funds have found themselves in "crowded trades," and when something goes wrong, and the crowd heads for the exits, the losses are large and come swiftly.
Many funds have been way under-diversified. Their concentrated positions often resulted from following other self-styled experts whose positions on both the long and short side were proudly and widely touted. Think Valeant Pharmaceuticals on the long side or Caterpillar Tractor among the shorts. The simple fact is that very few of these managers are able to outperform the broad market indexes consistently unless they are benefiting from very strong tailwinds and high leverage. At some point interest rates will rise and the cost of leverage will increase more than proportionally. Equity prices are likely to decline as well, and unless a fund is net short, its results are likely to suffer.
In addition, the traditional 2 and 20 fee structure, plus high transaction costs and the fees paid to feeder funds, put performance at a disadvantage unless stocks are roaring ahead. Also, since most of the gains these funds achieve are short term, the tax burden renders them poor risk adjusted investments for domestic taxpayers. Moreover, many funds have multi-year lockups, which greatly reduce the ability of dissatisfied investors to cash out quickly.
The rise of the ETFs has injected not only extreme volatility in the stock market; it also causes "innocent bystanders" to get crushed when just one constituent of an ETF sells off, because every other position goes down as traders rush to sell the ETF itself. Market volatility has also increased enormously in recent years as computer driven algorithmic traders jump on every bit of news and data, economic or even political. This makes it nearly impossible for a fundamentally based strategy to cope.
Finally, the evidence so far suggests that the current economic expansion will grind along at a 2%+/- pace for quite some time. Corporate earnings will also continue to rise at a modest pace. The odds of a near term market selloff deep enough to give these funds a fresh running start are not high, to say the least. Belatedly, to be sure, more and more large institutional investors in hedge funds are likely to cash out. Any fund that is forced to raise cash to meet redemptions is bound to underperform its benchmark and quite likely in absolute terms as well. Perhaps the saddest factor is that often those redeeming their interests in poorly performing funds end up reinvesting the proceeds into passive investment vehicles which admittedly have low fee structures but can only offer average to mediocre performance with no flexibility to adjust to changes in circumstances.
Perhaps the best summary of our position was stated by Warren Buffet in his 2016 letter to Berkshire Hathaway shareholders. We quote as follows:
“Finally, there are three connected realities that cause investing success to breed failure. First, a good record quickly attracts a torrent of money. Second, huge sums invariably act as an anchor on investment performance: What is easy with millions, struggles with billions. Third, most managers will nevertheless seek new money because of their personal equation – namely, the more funds they have under management, the more their fees.”
“The bottom line: When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients.”