The Fall of Hedge Funds

Hedge funds are high-risk alternative investments where fund managers aim to achieve an acceptable absolute return for investors regardless of the market condition. These managers often aggressively exploit identifiable market opportunities by utilizing strategies such as short-selling and leverage to beat the market, which makes these funds useful instruments for portfolio diversification. Like bonds, hedge funds possess a low correlation with the stock market and are more desirable as they often achieve significantly higher gains, enabling these funds to raise an investor’s returns while reducing the correlation of their portfolio.

However, recent performance of these funds have fell short of client’s expectations, causing more investors to abandon these investment vehicles. The long-short equity fund from AQR, which is a popular mutual fund that uses hedge fund strategies to create value for its investors, have achieved weaker returns than the S&P 500 index for the past year even though the fund has lower costs than a traditional hedge fund. As illustrated from the graph, a continuous gap is evident through January to November between the S&P500 index and AQR’s equity fund, denoted by the red SPX:IND and the blue QLEXN lines respectively. Reports from Bloomberg show that due to their underperformance against market benchmarks, the hedge fund industry is shrinking as investors lose interest in these investment products.

Due to the characteristics of hedge fund’s operations, the industry’s current situation has led to a survival of the fittest. Hedge funds have an astounding 43% tax on capital gains, higher than any other fund, and a remarkably high management fee of 2% of total assets plus 20% of the fund’s profit. When investing in broad market segments, unless the past performance of an actively managed hedge-fund can justify these costs, investors are generally more willing to put their money into alternative investment vehicles. In addition, to protect their profitability, hedge funds are also unwilling to disclose detailed information regarding their management activities to their clients. This creates a need for hedge fund firms to be exempted from SEC regulations, which is only achievably by giving access exclusively to accredited and wealthy investors in addition to requiring a minimum investment up to $1 million.

Furthermore, hedge funds also have a lock-up period of up to one year where the investors cannot withdraw any money from their investment. All these features make hedge funds a high cost, low transparency and illiquid investment. Hence, the hedge funds that compensate investors with high returns will still be profitable but those that are unable to do so will struggle to surivive the next fiscal year. Since hedge funds usually navigate better during market downturns, the current bull market has made it hard for these funds to outperform and prove their value. As a result, countless hedge funds have been falling short against their market benchmarks and have experienced a rapid loss of interest from investors, ultimately being forced to shutdown.

Unless the the way hedge funds are managed is altered, their future survival will be contingent on a marked shift in the strong performance of the market. If the general market continues to perform well, the subpar returns and high cost structure of hedge funds will inevitably sink this struggling industry.

References:

https://www.washingtonpost.com/business/economy/once-considered-the-titans-of-wall-street-hedge-fund-managers-are-in-trouble/2017/05/29/61049f1e-34ce-11e7-b373-418f6849a004_story.html

http://uk.businessinsider.com/end-of-hedge-funds-as-we-know-it-2016-5

https://hbswk.hbs.edu/item/the-problem-with-hedge-funds https://www.vanityfair.com/news/2016/09/hedge-fund-fees