Why 99% of Hedge Funds Are Living on Borrowed Time

Hedge funds were supposed to be the ultimate “insider” investment vehicle. Managers would be able to do whatever they wanted – go long, go short, buy bonds, buy commodities, or do whatever they thought was necessary to earn high returns for their investors.

The idea was that hedge fund managers, given the latitude available to them, should be able to do well no matter what the stock market did in a given year.

It was investment nirvana, and tickets to the show were not cheap: Joining hedge fund royalty would cost you “two and twenty,” which is to say 2% of assets and 20% of profits.

The first hedge fund was introduced back in 1949 by Alfred Winslow Jones. It performed very well; Jones was long stocks he liked and – as a hedge short stocks he didn’t.

The returns were solid, and it did, in fact, do pretty well no matter what the market did. His success gained imitators, and the industry grew steadily throughout the 1950s and 60s.

But people will always be greedy, and greed will always make you stupid. That’s what happened to hedge funds as the 1970s approached.

Some fund managers wanted to be the best, so they figured if they just bought the best stocks and left out the whole “hedging” idea, they would gain an edge over their competitors.

They did – until they didn’t.

The bear market of the 1970s left the un-hedged hedge funds exposed, and the losses were enormous.

The hit was so punishing, in fact, that it left hedge funds out of favor until the 1990s.

Then things changed…

The Dawn of the “Rock Star” Fund Managers

“Money guys” like Julian Robertson, George Soros, and Paul Tudor Jones began making headlines with enormous returns for their investors.

Just like the little kids that dream of growing up to play center field for the Yankees or quarterback for their favorite NFL team, every newly minted finance major dreamed of someday opening their own hedge fund. Being able to command the “two and twenty” was a path to fame and (more importantly) fortune, and new funds were opening at a rapid pace.

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We saw these killer instincts on full display during the credit crisis when folks like John Paulson, Michael Burry, and Steve Eisman made billions by correctly foreseeing the meltdown.

These folks and their investors made enormous piles of money as everyone around them was experiencing hideous losses.

The media began to call this clutch of uber-investors the “masters of the universe.”

Naturally, demand for these wondrous investment vehicles went up enormously, and new hedge funds were popping up everywhere.

More and more masters were popping up in an increasingly crowded universe.

But it was still all good – no one was rocking the boat, asking uncomfortable “Just what the hell am I paying you for?”–type awkward questions…

… yet.

I Can’t Believe People Are Paying Money for This

Of course, these funds all charge some permutation of the “two and twenty” fee structure… but they do not all outperform the markets – or offer protection – you know, “hedging” – during declines.

In fact, to call their performance “mediocre” is to be unreasonably charitable.

According to Barclay Hedge, a research firm that maintains a massive hedge fund database, as a group, the “masters of the universe” are lagging even index funds – and badly to boot.

Just look at this average return performance by year – and bear in mind that high net worth folks gladly forked over their “two and twenty” for it:

2014… 2.88%

2015… 0.04%

2016… 6.10%

2017… 10.36%

2018 (year to date)… 0.48%

In 2017 – an extremely bullish year in which one would have to try very, very hard to not make money – the mighty hedge funds returned around 10.3%, which sounds okay… until you recall that the S&P 500 zoomed 19%!

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As you might expect, that’s causing many larger investors to question exactly why they are paying such high fees for this “performance.”

In fact, the topic of fees is becoming one of central importance in the investment-management industry today.

Started by Jack Bogle of Vanguard, the idea of owning the market index at a very low cost as a way of capturing equity market returns is catching on in a big way.

(Of course, even those costs are too high, and indexing is a racket, too, but we’ve already covered that.)

The thinking goes, “Why should I pay some hotshot money manager the ‘two and twenty’ when I can earn market returns for less than 10 basis points of cost?”

This school of thought holds that one cannot control what the market does, but one can control costs, so that’s where one should focus – instead of trying to shoot for the moon.

As a result, investors are pulling money away from active, expensive money managers and putting it into low-cost index products.

It’s a terrible, stupid idea, but the fact remains: It’s really hurting the hedge fund racket industry.

In 2017, we saw as many funds close, and we saw new ones form. In total, 1,057 hedge funds closed their doors in 2016, and another 784 went extinct in 2017. In the first quarter of 2018, we saw another 145 hedge funds go away for good.

There are still around twice as many hedge funds as there are stocks on U.S. exchanges.

These hedge funds face a fundamental, existential problem: The success of the funds has attracted new money, and that creates a crowded ecosystem.

Although hedge funds can branch out from stocks to trade in fixed-income, currency, and commodities markets, the simple truth is that there are only so many successful, time-tested strategies in play in the markets.

Too many dollars chasing those few ideas is going to compress returns.

The “two and twenty” is an easy ask when you’re a John Paulson, putting up big numbers in good markets or bad.

But when you’re pulling in single-digit returns, lagging a raging bull market by eight or nine points (or worse, losing money) your investors will leave – and rightly so.

Hedge funds have another problem – and it’s one I’m determined to help create.

Independent Research Always Beats Marketed Mediocrity

It’s not always easy, but if you spend enough time tracking their trades, you can do a good job of reverse engineering what the best fund managers are doing with their clients’ money.

I’m talking about 13F filings. They’re like a list of securities money managers own as of the end of the most recent quarter. By law, these managers have to file them with the Securities and Exchange Commission every quarter.

And for every hundred Brioni-wearing hacks running closet index funds, there’s one beautiful, godlike financial genius playing the market like a Stradivarius, thinking five moves ahead, and pulling down obscene piles of money.

These are the folks who are worth their “two and twenty,” and those are the filings I like to get my hands on.

That’s right: We can replicate pretty closely their investing strategy. That means we can reap the gains – and keep our “two and twenty” in our pockets.

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