How Hedge Funds Lost Their Way and Why They’ll Come Back
Equity hedge funds once ruled the investing world. During their heyday in the 1990s and 2000s, hedgies seemed to have a freakish gift for picking stocks, racking up big returns for their clients and themselves. Investors begged to get in, and only the richest and most connected among them got a nod, which made hedge funds all the more alluring.
Then, suddenly and mysteriously, they seemed to lose their touch. The HFRI Equity Hedge Total Index returned 14% a year from inception in 1990 through the financial crisis in 2008, doubling the total return of the S&P 500 Index. Since 2009, however, the tables have turned. The HFRI index has returned 8% a year through February, roughly half the return of the S&P 500.
To understand what happened, and why fortune may return for equity hedge funds, it helps to know a bit about how stock pickers make money for investors. They basically have three levers. The first, and by far the most consequential, is merely owning a broad basket of stocks, which all but guarantees that their portfolio will move in close step with the stock market. Not surprisingly, the HFRI index has been strongly correlated with both the U.S. stock market (0.76 with S&P 500) and the global stock market (0.78 with MSCI All Country World Index) since 1990. (A correlation of 1 implies that two variables move perfectly in the same direction, whereas a correlation of negative 1 implies that two variables move perfectly in the opposite direction.) In other words, when the stock market goes up, so do most stock portfolios.
Second, and far less consequential, is the stock pickers’ preferred style of investing. A picker with a penchant for growth stocks, for example, is likely to outpace the market when growth stocks are in favor. The same is true for any other style of investing, be it value, momentum, quality or something else.
Third, and almost entirely inconsequential, are the specific stocks selected. Sure, it’s possible that after accounting for the performance of the broad market and the manager’s preferred style, that manager will have added some value by picking one growth stock rather than another, to extend the previous example. But it’s exceedingly unlikely.
In sum, the return from stock picking = market + style + stock selection.
That simple equation has profound implications. It means that, with rare exception, what distinguishes one stock picker from another is style because most pickers are exposed to the market, and the specific stocks they choose are largely irrelevant. As a result, stock picking comes down to being in the right style at the right time. Growth managers will fare best when growth investing is hot, and value managers will shine when value investing has the edge, and so on.
That’s a problem for most stock pickers because they’re often confined to one style. Someone who manages a U.S. large-cap growth mutual fund, for instance, can’t decide to start buying small value companies in emerging markets. But this is where hedgies have a distinct advantage because they’re generally free to invest anywhere.
And they have. Dynamic Beta Investments is a fund manager that attempts to replicate the performance of equity hedge funds. Using a method known as performance attribution, it looked at how hedge funds in the HFRI index have been invested going back to 2004. It found that the index’s performance can be replicated with five investments available to everyone: cash, large-cap U.S. stocks (S&P 500), small-cap U.S. stocks (Russell 2000 Index), international stocks (MSCI EAFE Index) and emerging-market stocks (MSCI Emerging Markets Index).
The key is that hedge funds’ exposure to those investments appears to have varied considerably over time. From 2004 to 2008, they had big bets on foreign stocks and small U.S. companies and against large U.S. companies. That turned out to be a good move because foreign markets and Russell 2000 companies posted big gains in the years leading up to the financial crisis, while the S&P 500 was hobbled by the hangover from the dot-com bust years earlier. Hedge funds also doubled down on emerging markets in 2009 and 2010, another savvy move because developing countries led the recovery after the financial crisis.
Hedge funds don’t always get it right, though. In 2016, they ramped up investments in foreign stocks and small companies and drew down their exposure to large U.S. companies. That was a costly mistake; the S&P 500 has been the best performer in recent years. But this is where flexibility helps. In late 2019, hedge funds reversed course and threw money into large U.S. companies, particularly technology stocks. They also leaned more heavily into small companies and emerging markets. Those moves paid off, first when Big Tech led the initial market recovery from Covid-19 last spring and more recently when small companies and emerging markets joined the rally.
In fact, the HFRI index has outpaced the S&P 500 by 5 percentage points since 2020 through February. And that’s net of hedge funds’ hefty fees, customarily a 2% management fee and 20% of profits. Before fees, the HFRI index beat the S&P 500 by closer to 17 percentage points. Now hedge funds appear to be on the move again, swapping some of their high-flying tech stocks for cheaper financials. If the recent resurgence of value stocks, small companies and foreign markets continues, hedge funds may stage a resurgence of their own.
Only this time, anyone can invest alongside hedge funds, and without paying their exorbitant fees. I counted 48 ETFs that either replicate equity hedge funds, like Dynamic Beta, or offer their own long-short strategy, all but one of which debuted after 2009. Their expense ratios vary from 0.4% to 2% a year, which isn’t cheap but is still considerably cheaper than 2-and-20. There’s no guarantee those ETFs will keep up with hedge funds, of course. But given the considerable fee advantage, they could fall well short of what hedgies manage to produce and still fare better than hedge fund investors after fees.
The last few years have been unusually cruel to stock pickers. Most of the gains went to just a handful of large U.S. companies, which made the S&P 500 impossible to catch. That may have already begun to change. Even so, hedge funds are unlikely to recreate their golden era — there’s too much competition and too much money chasing too few opportunities. But don’t be surprised if hedge funds navigate to the right place at the right time yet again and rejoin investors’ roll of must-have investments.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Nir Kaissar is a Bloomberg Opinion columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.
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