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The Fall of Hedge Funds?

Hedge funds have underperformed more traditional asset classes such as equities in recent years. Investors always chase yesterday’s returns. Adjusted properly for risk and the absence of liquidity, hedge funds return at best no more than—and frequently less than—traditional assets.

A recent study found that hedge fund performance doesn’t appear to deliver alpha consistently. [15] There are exceptions, but they’re few and far between. Many of the really good hedge funds are closed to investors. Even where you can invest, the flow of funds into better-performing funds rapidly erodes returns. Too much money is chasing too few opportunities. Clever people can make money if there are only a few clever people and lots of opportunities. This is scalability—what works on a small scale cannot work on a larger scale. In 2004, Hilary Till argued that the maximum size of the hedge fund industry was 6% of institutional (and high net worth) assets. [16] There are other constraints. Some hedge fund strategies need liquid markets and a complete set of instruments. There are few such markets.

Ultimately, if you make money from inefficiency, someone—other investors—must supply the inefficiency. We cannot all exploit inefficiencies, as nobody would be supplying the market inefficiency in the first place. To be "alternative," there has to be a majority; the alternative cannot be the majority.

Hedge funds with certain areas of expertise began to trade in other markets as opportunities became limited, creating "style drift." LTCM had drifted from their métier—relative-value trading in fixed income—into volatility trading, credit-spread trading, and merger arbitrage. Lack of disclosure meant that you didn’t know how far the ship was off course until it was on the rocks. Cases of fraud and other common crimes had also begun to surface.

Smart investors know that there’s no money to be made from investing in hedge funds. In investing, the majority is always wrong. The focus is now "incubators"—venture capital for hedge funds. They identify traders, seed startups, and allow them to establish a track record. Once established, the hedge fund seeks third-party funding, allowing the original investors to exit. They retain the real money—a free carry or shareholding in the general partner or fund manager. Incubators are only open to the really rich and connected.

The hedge fund universe is overheated. At the suggestion of a "bubble," one hedge manager bristled that hedge funds weren’t an "asset class," and therefore there was no "bubble" to burst—only asset classes experienced bubbles. Another hedge fund apologist argued that all funds managers in the future would be hedge funds. The semantics aren’t reassuring.

Hedge funds are also under attack from clones. Hedge fund performance doesn’t depend significantly on skill, nor is it as distinctive as the Masters of the Universe claim. In fact, hedge fund returns can be replicated using readily available instruments such as equity index futures and corporate bonds. [17] Banks are starting to clone hedge funds using precisely these instruments. [18] The advantage for investors is lower fees, with the risk of blowups like Amaranth or LTCM. The clones are not the real thing—they’re cheap reproductions. Some analysts argue that the replication models are flawed, though they have their own version that works.

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