For almost ten years now, hedge funds have been underperforming their benchmarks.
Even the biggest and historically best performing funds are underwhelming investors, who aren’t sticking around just because managers are lowering their exorbitant fees.
They’re fleeing in droves for passive investing strategies like index funds.
But don’t count the Masters of the Universe out just yet.
Not only are hedge fund managers figuring out what’s causing their underperformance, the headlong rush by investors into index funds and exchange-traded funds could backfire, making hedge fund escapees wish they’d stuck to their guns.
Here’s why passive strategies have become so popular, how much money has been moved into them, and why that trend could turn out to be devastating…
Overcrowding Doomed Hedge Funds
Hedge funds have underperformed investor expectations and the benchmarks they’re supposed to beat since 2008. Only a handful of so-called hedge funds actually made money hedging the subprime mortgage meltdown in 2008, the rest of the industry took it on the chin.
Still, fund managers got a break from investors who stuck around expecting better results in what looked like a tough market going forward.
They bet the wrong way.
From 2009 through the first quarter of 2016, hedge funds underperformed the S&P 500 (the most widely watched U.S, equity market index and benchmark) by 51 percentage points, according to Standard & Poor’s.
As a result, hedge funds have been losing investors and closing up shop. In 2015, according to Hedge Fund Research Inc. (HFR), more hedge funds shut down than any time since 2009, while 2015 also saw the fewest start-ups since 2008, before the credit crisis hit.
Some 530 funds were liquidated in the first half of 2016, the most since 2008. And hundreds of billions of dollars of investor money has flown out of funds, with another $51.5 billion withdrawn in the first nine months of 2016, says HFR.
Fund managers point to extraordinary market conditions, market manipulation, and their own inability to understand how global market conditions have changed and upended their traditionally successful strategies.
There’s plenty of truth there.
The Federal Reserve in the U.S. and central banks across the globe have manipulated interest rates to unprecedented, impossibly low levels, even into negative territory for almost $13 trillion of European and Japanese government bonds. On top of that, high frequency traders move markets in mysterious, self-serving and dangerous ways. The strangling of free market price discovery has upended strategies employed to profit from the normal ebbs and flows of free markets.
But the deeper truth, that managers readily acknowledge, is that the industry has become almost “commoditized” as the number of funds plying a lot of the same strategies has exploded. And, that some of the same strategies that used to be successful are actually working in reverse and surprising traders in profound ways.
While overcrowding into the same strategies and the same stocks presents monumental event risk and liquidity issues for a wide swath of funds, some of the usual tried and true strategies funds employ are simply not working, and worse, backfiring.
The most recent example is so-called momentum trades, both long and short varieties.
It used to be managers who found good buying or shorting opportunities were followed into those trades as word got out about their research, their positions, or a significant enough move in the targeted stocks to draw other investors’ attention.
While medium to longer-term holding periods, from months to quarters and even years, were the norm, short-term traders, algorithmic traders, countertrend traders and trading desks trying to agitate stocks to trip stop orders, have all radically changed the game.
After buying and enjoying positive momentum, backed by central banks’ reassurances they were in no hurry to raise rates, funds got sideswiped by the August 2015 10% selloff. After taking their lumps and dumping positions, the market recovered and zoomed higher in the fall. But hedge funds were too scared to initially jump back in.
After solid gains, the momentum crowd came back onboard. Only to get mugged violently again in February 2016 by another 10% smack-down.
Meantime, funds looking to jump onto declining shares by shorting stocks that were headed south, in a bid to rake in profits as the market slid, got their heads chopped off.
Funds got short Wynn Resorts Ltd. (NASDAQ:WYNN) in 2015 which was off 55%, but remarkably rose 35% in the first quarter of 2016. Range Resources Corp. (NYSE:RRC), another big hedge fund position, was also down 55% in 2015, and jumped 33% in early 2016. The same is true for Kate Spade & Co. (NYSE:KATE), down 45% in 2015 and jumped 45% in 2016’s first quarter.
The list goes on, and includes Dick’s Sporting Goods Inc. (NYSE:DKS) and Urban Outfitters Inc. (NASDAQ:URBN), both hedge fund shorts that reversed unexpectedly in 2016. It was enough to make managers scream and investors flee.
Whether overcrowding is undermining hedge fund strategies or strategies themselves are backfiring, the net underperformance of funds with their high fees (relative to their indexed benchmarks with their negligible fees) is driving investors to passive investing strategies, namely indexed mutual funds and indexed ETF products.
The Flood Pushed Billions into Passive Strategies
Hedge fund investors fleeing to indexed mutual funds and ETFs already have lots of company.
In the three years ending August 31, 2016, according to Morningstar, investors of all stripes pumped slightly more than $1.3 trillion into passive mutual funds and ETFs. Of that amount, some $250 billion was stripped from “active” mutual fund managers trying to beat their benchmarks.
While 66% of mutual funds are still active funds, that’s down 84% over the past 10 years. Between 71% and 93% of mutual funds in the ten years (depending on the type of fund) closed or underperformed the indexes they were trying to beat, says Morningstar.
Passive investing is simply buying and tracking an index as opposed to paying a money manager to actively try and beat the market or an index. Over the past 40 years – since Vanguard Group’s John Bogle launched a passively managed S&P 500 index mutual fund – almost 30% of mutual and exchange-traded funds are now “index funds,” according to the Investment Company Institute. The ICI says that’s double their share a decade ago and eight times their share 20 years ago.
So… the trend’s your friend, right?
Sure it is. But the trend changes.
Passive indexing isn’t the answer a lot of its proponents want you to believe it is.
For one thing, stocks in any index can become overvalued relative to those outside it.
Index investors have little choice but to ride overvalued stocks down just like they did when hot technology indexes that drew in tons of money in the 1990s crashed violently in 2000.
Of course, most passive investing fans are huge fans of Warren Buffett because they consider him the ultimate passive investor.
But he’s not that at all.
While a dollar invested in Buffett’s Berkshire Hathaway Inc. between 1965 and 2015 grew an awesome 136 times as much as one dollar invested in the S&P 500, Buffett himself once admitted, “I’d be a bum on the street with a tin cup if markets were always efficient.”
In other words, he’s always trying to find value stocks and inefficiently priced shares, as opposed to just buying an index or the whole market.
The truth is, when active investing re-emerges and beats the pants off passive funds, probably starting right when the masses now rushing into indexed strategies head for the fire exits when investors not in those funds sell stocks, tanking passive funds whose managers have no choice but to go down with their ships.
Mass redemptions and a self-inflicted crash is going to make a lot of passive investors wish they followed a smart hedge fund manager.
On Friday, I’ll tell you what hedge fund managers have learned and what the smart ones are doing now.