Equity-oriented hedge funds have lagged the market during its decade-long bull run, resulting in three years of net withdrawals by investors, the longest period of outflows since 1990, according to data from research firm HFR Inc., cited in a detailed report by the Wall Street Journal. As a consequence, many of these funds, even some with previously great reputations and top managers, are being forced to shut.1

From 1990 to 2009, equity-focused hedge funds outperformed the S&P 500 Index by almost 5% each year on average. Since 2010, they have underperformed the index by more than 9 percentage points every year on average. "Investors are frustrated," Greg Dowling of Fund Evaluation Group, an investment consulting business, told the Journal. "Clients expect them to underperform in a raging bull market, but not by a huge degree, for years on end," he said.

Lagging Performance

In 2019, hedge funds were laggards. According to statistics from BarclayHedge (quoted in another Journal piece), the average hedge fund had a net return of just 17.2%, while the S&P 500 earned roughly 30%. So-called "equity long bias funds," which provide substantially unhedged exposure to equities, performed the best, but with an average return of 20.6%.2

Jeff Vinik, who replaced Peter Lynch as manager of the Fidelity Magellan Fund in 1990, has just passed away. Vinik then became a hedge fund manager, closing the fund in 2013 but reopening it in 2019. He aimed to raise $3 billion in two months, but only received $465 million. In October 2019, he chose to stop again.

"What I learned after probably 75 meetings is the hedge fund industry of 2019 is very different than the hedge fund industry when I started in 1996, and it's even very different from the hedge fund industry when I closed in 2013," said Vinik. One issue is the rapid increase of competition. Hedge funds have grown from 530 in 1990 to 8,200 now, with total assets under management (AUM) rising from $39 billion to $3.2 trillion. 

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High fees.

Fees are under pressure. Traditionally, these have been 2% of AUM each year plus 20% of any investment profits, known as the "two and twenty" fee structure. A rising number of hedge firms feel obligated to offer lower fees. In comparison, the three biggest ETFs tracking the S&P 500 have annual cost ratios ranging from 0.03% to 0.09%.

Another concern is the increasing expansion of quantitative and passive investment. The former exploits price anomalies faster than human hedge fund managers. The latter has contributed to a market in which equities are more connected. According to JPMorgan Chase & Co. study, the share of stock trading handled by human stock pickers has decreased from about 45% in the late 1990s to roughly 15% now.

Illiquid Funds

Another issue with hedge funds is that many of them hold investor money for extended periods of time. In other words, even if the fund performs poorly, an investor cannot redeem (withdraw) their money for a period of months or years. Hedge funds may be difficult to exit during economic downturns due to their illiquid nature.

The lock-up period allows hedge fund managers to plan their strategy and exit positions smoothly. Hedge fund lock-ups are normally 30-90 days long, allowing the hedge fund management to leave positions without pushing prices against their total portfolio, although they may last a year or more.

The Bottom Line

Despite net redemptions of $23 billion in the first half of 2019, overall hedge fund assets increased to a record $3.25 trillion, up from $3.1 trillion at the start of the year, according to statistics from Hedge Fund Research cited by the Journal.2 While performance was poor, it was sufficient to counterbalance net withdrawals of capital. However, prolonged underperformance will undoubtedly drive even more investors out of the market. 

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