“Let them sell their summer homes and jets, and return those fees to their investors.”

– Letitia James, Public Advocate for the New York City Employees’ Retirement System, which voted in April 2016 to liquidate its hedge funds investments, as quoted in FT.com

Fire Sign

Decapitalization, the worst returns since the great recession, a bizarre fraud conviction, bets losing billions, and systemic issues – hedge funds have been making the news for all the wrong reasons.

Columnists are now debating whether or not hedge funds, as an asset class, are dead, dying or merely not feeling well. According to The Economist, recent fund closures and expectations that more will follow, “suggest the industry’s era of stratospheric growth may be in the past.”

A chart at Bloomberg.com graphically illustrates its title, “Hedge Funds Bleed Cash as Returns Disappoint Investors.” According to Hedge Fund Research, Inc., during the first quarter of 2016, assets managed by hedge funds managers posted losses and investors withdrew a net $15.1 billion, the most since the second quarter of 2009. Macro hedge funds suffered $7.3 billion in outflows, while event-driven money managers saw about $8.3 billion pulled out.

Speaking at the Canadian Venture Capital and Private Equity Association’s annual conference, Blackstone’s Tony James says funds could lose 25% of their assets in the next year. “We’re definitely worried about what’s going to happen in the hedge-fund world right now,” said James. He added in an interview with Bloomberg TV Canada’s Pamela Ritchie at the conference, “It’s kind of a day of reckoning that we face here.” The New York-based investment firm Blackstone is the largest allocator to hedge funds globally.

K.C. Nelson, lead fund manager at Driehaus Capital Management expects “a culling of hedge funds like we’ve never seen before,” he said in a letter to investors. “I’d estimate the number of funds gets cut in half over the next couple of years.” According to Business Insider, Nelson titled his commentary, “Hedge Fund Apocalypse.”

Why are investors pulling their money and searching for greener pastures?

Below are five reasons that the hedge fund party may have peaked, peppered with some too-true humor from Morgan Housel’s spoof on Fool.com, “Two Hedge Fund Managers Walk Into a Bar“:

  1. Lagging Performance.

“One dollar invested in the Barclay Hedge Fund Index in 2004 would worth be worth $1.88 by 2014. In the S&P 500, it would have grown to $2.32…”

“What do you tell clients who are upset with your performance?”

“We tell them we’re not trying to beat the market. We’re trying to manage risk.”

“Jim, seriously, what the hell does that mean?” Paul asks.

Jim throws back his third whisky and bursts out laughing.

“…You convince them that we have less downside risk than the market. So even though your returns are terrible, you can tell them you have excellent risk-adjusted returns. Throw in some formulas with Greek symbols, and they’ll leave you alone.”

Hedge funds have promised stock-like gains coupled with more sedate bond-like stability. And amazingly, the hedge funds that make up the HFRI Fund Weighted Composite Index collectively delivered returns beating stocks and bonds (or any combination of the two) for a number of years. According to figures provided by Bloomberg.com in a March 24, 2016, article, “Hedge Funds Have a Performance Problem,” from January 1990 to February 2016, the HFRI returned impressive an impressive 10 percent annually. The S&P Index returned 9% during that same period.

However, the Index’s long-term performance masks the truth of the trend: hedge fund returns have trended steadily downward since the launch of the hedge fund index. “The HFRI Index returned 18.3 percent annually during its inaugural ten years from 1990 to 1999, and it returned just 3.4 percent annually over the last ten years. Draw a straight downward-sloping line between those two numbers and you pretty much have the picture,” says Nir Kaissar in the Bloomberg article.

And in case the numbers don’t tell the story vividly enough, Bloomberg’s chart vividly illustrates the steady decline of hedge fund returns. (See screenshot below, follow link for interactive chart on Bloomberg.com.)

Bloomberg-hedge-fund-chart

Hedge funds aren’t just underperforming the market, they are also underperforming other alternative investments. A CEM Benchmarking study of asset class performance from 1998 to 2011 sponsored by NAREIT found hedge funds trailing the other  alternative investments and real assets with an annualized net return of only 4.77% for that period of time.

  1. Exorbitant Fees.

“Most hedge funds are indistinguishable from mutual funds, other than the fact that they feel entitled to charge 30 times the fees… Two percent of assets for showing up in the morning, and 20% of any profits.”

“…Look, you can get a lower volatility portfolio by putting 60% of your money in Vanguard stock funds and 40% in Vanguard bond funds,” Jim explains…. “You pay basically nothing in fees. Everyone knows this.”

“But how many Vanguard fund managers own a Gulfstream V?”

“I rest my case.”

Cash OnlyFees as high as 2% plus 20% of gains is indeed common. In theory, this commission structure encourages managers (who may have their own money in the fund) to perform in order to maximize their own profits as well as the gains for their investors. In practice, as the chart in this article, “Hedge Funds: What Are They Good For?” illustrates, too often hedge funds merely drain huge amounts of capital from investors to managers, whether funds are gaining or losing.

Hedge fund fees have drawn criticism from high-profile money managers and investors. Bill Gross of Janus Capital Group Inc. posted on Twitter: “Hedge fund fees exposed for what they are: a giant ripoff.” Billionaire Warren Buffet calls typical hedge fund compensation “unbelievable,” encouraging pension funds and endowments to shun hedge funds, according to Bloomberg.com.  “There’s been far, far, far more money made by people in Wall Street through salesmanship abilities than through investment abilities,” Buffett said during Berkshire’s annual meeting in April 2016.

More recently, compensation critique is also coming from the industry itself, though perhaps for different reasons. BlueCrest Capital, until recently the third-largest hedge fund firm, is one of several high-profile funds that closed to outside investors this past year. In December 2015, fund co- founder Michael Platt told investors he would return their money, claimed the industry’s fee model was “no longer a particularly profitable business,” according to Economist.com. With an estimated net worth of 3.5 billion and with industry-wide pressure to lower commission structures, “Platt thinks that managing outside money for a management fee that is less than 2% of assets under management isn’t worth the trouble,” mused Nathan Vardi in a Forbes.com article.

  1. A Talent Shortage.

“A lot of us are smart people. Brilliant, actually. But when 10,000 people fight for the same prize in the same market, the results are totally predictable.”

“Part of the problem is there are so few barriers to entry in this business. You have to be drafted to play in the NBA. But any hooligan can start a hedge fund.”

“And call themselves the next LeBron James.”

“And convince investors they should be paid like a champ.”

Now Hiring SignSince the start of the HFRI Index fund, the number of hedge funds has exploded from around 500 to approximately 10,000.

Some hedge funds have established managers, but others go through them like interns, hiring several, giving them money to invest, and cutting them quickly if they can’t deliver.

During the shortage of hedge fund managers, even a fraud started fake hedge funds to get in on the action, much to the regret of the “investors” who were fleeced. Moazzam Ifzal “Mark” Malik was convicted of stealing over $800,000 from investors for several “funds” from 2011 to 2015. Most of the money was used for his personal expenses, purchases, and trips.

Malik is also infamous for “faking his death” when stalling an investor who wanted their money back, sending an email from an “assistant” delivering the news. In reality, Malik was no hedge fund manager, only a wannabe and a thief. Once a trainee at a financial consulting firm, Malik and was only registered as a broker from 2007-2009. Attorney General Eric Schneiderman’s statement noted Malik’s real jobs included working as a security guard, waiter and traffic agent.

In reality, most hedge fund managers are highly educated, experienced investors. But is there really enough talent to go around with 10,000 hedge funds in existence?

  1. Barriers to Entry and Exit.

“There are probably 100 hedge funds that will consistently beat the market after fees. They won’t take your money. They provide just enough hope for investors to keep the rest of us in business. We earn half the performance of index funds, charge 30 times the fees of mutual funds, pay half the income tax rates of school teachers, have triple the ego of rock stars, and fewer disclosure requirements than the NSA.”

Restricted Area vector sign illustrationLet’s say that, in spite of hedge fund problems of uncertain performance, lack of disclosure and high fees, you’re feeling lucky and want to play hedge fund roulette. Investors must have a degree of wealth to begin hedge fund investing. Only accredited investors with $1 million or more in net worth are allowed in, and many funds require a minimum of a $1 million investment. The best performing funds can require more, and waiting lists are not uncommon.

While top performers can sometimes “hit it out of the park,” the reality for many investors is that their money is tied up in an underperforming asset with high fees and no guarantees. And even respected hedge funds can sometimes make serious miscalculations. Pershing Square Holdings was one of the best performing hedge funds in 2014, but two of fund owner William Ackman’s bets proved disastrous, and the fund has lost a staggering 40% over the last year. (Perhaps it is a good thing that only those with significant assets are allowed at the hedge fund table.)

However, Pershing Square investors who wish to exit face their own challenges. Only 1/8 of an investors assets may be withdrawn per quarter, so it would take 2 years for an investor to divest themselves. (Each fund has its own rules, which typically include lockdown provisions.)

Hedge funds have been popular with pension funds after the 2008-2009 financial crisis in an effort to diversify, but now some pension funds across the country are beginning to dump their hedge fund investments. And though pension funds for thousands of employees can technically “afford” to invest in hedge funds, the employees the pensions represent cannot afford to gamble their retirement savings. The New York City Employees’ Retirement System paid about $40 million in fees to hedge fund managers, and the three-year returns average 2.83%.

In spite of a few notable pension funds retreating, other institutional investors and pension plans are in the process of committing new monies to hedge funds. It may take some time for institutional investors to reach the conclusion a number of wealthy individuals have reached… that hedge funds are no longer a good bet. The once-golden goose cannot be counted on for golden eggs, and if Bloomberg’s analysis is correct, the over-abundance of investors who have flocked to them may be partly to blame!

  1. Dilution of Strategies and Profits.

“There are 10,000 hedge funds in the world,” Jim says to his friend, Paul. “Every one is run by a guy who thinks he’s George Soros. No one thinks of himself as a mediocre hedge fund manager. Everyone thinks they’re the Stephen Hawking of finance.”

“Here’s the problem,” Jim continues. “Most of us went to the same schools, were taught the same theories by the same textbooks, worked at the same investment bank, read the same newspapers, and live in the same zip code. We take money from the same investors who demand the same short-term performance.”

“Yet we deeply – deeply — believe we have an edge over everyone else.”

The crowd of abstract people. Flat design, vector illustration.“The thrill is gone,” laments Kaissar, noting that the explosion of hedge funds over the last 10 years to 10,000 funds and 2.9 trillion in assets has led to a critical shortage of the two things necessary for hedge funds to succeed: “skilled managers and exploitable market inefficiencies, and there simply isn’t enough of either to support a $2.9 trillion industry.”

Ironically, instead of capitalizing on market inefficiencies, hedge funds are creating a market inefficiency. And the more hedge fund investors there are, and the more bets each fund tries to hedge, the more inefficient they become.

“You can’t hedge the world,” said Paul Volcker, former Federal Reserve Chairman. Indeed, it would be impossible to insure yourself against any possible downturn, because, as David John Marotta added in a Forbes.com article,  “if you tried to, it would cost too much.”

This is precisely the downside of hedging. It can be an effective way to mitigate risk – but it’s a bit like accelerating with your brakes on. All of the hedge funds are trying the same strategies, and the strategies are no longer working in such volume or in current market conditions. It seems that hedge funds have run out of ways to keep pace with the market, much less beat it (or even lag it with greater stability) – with or without the exorbitant fees.

Tired of Hedging Your Bets – And Losing?

If you are an accredited investor looking for a hedge fund alternative, Partners for Prosperity currently has access to alternative investments (not hedge funds!) outside of the stock market. We have options for non-correlated asset growth and also cash flow for those who would like to receive a check each month from their investments. Contact us for further information about investments that deliver healthy returns (often in the low double digits) without the volatility of the market.

You can also find out more about our investment philosophy, Prosperity Economics, and an overview of our favorite alternative investments in our ebook, Financial Planning Has Failed. Sign up for instant access to our Prosperity Accelerator Pack and receive the ebook, along with a video, audio, and some of our most popular past articles.