In a year when expectations ran high for the beleaguered hedge fund industry, hedge funds once again wilted under unspectacular returns in 2015. Coming off a disappointing performance in 2014, hedge funds were under increasing pressure from investors who watched their alternative investments consistently underperform the S&P 500. Many hedge funds began the year strong, even outpacing the S&P 500, but could not manage the year-end crosswinds. At year end, the average hedge fund lost more than 3%, while the S&P 500 managed a microscopic gain of 1.4% including dividends. The consistent year-over-year underperformance by hedge funds has many investors questioning whether the high fees they are paying are worth it.

How Hedge Fund Managers Earn Their Pay

Investors pay hedge fund managers to control risk and manage volatility. They are designed to be a noncorrelating asset to provide ballast to stock- and bond-based investment portfolios. In doing so, they are expected to generate better risk-adjusted returns, especially through periods of extreme volatility. The last year the hedge fund index outperformed the S&P 500 was 2008 when it fell just 27% to the Index’s 38%. In the years since, there have been fiscal cliffs, Arab Springs, European financial bailouts and plenty of other macro-events that require deft asset management to overcome.

In 2015, there was no financial crisis. There was no major outbreak of war. China grew weaker, but the U.S. economy showed signs of core strength. With the exception of falling oil and commodity prices, there were really no major headwinds that hedge fund managers had to fight. The S&P 500 started the year off strong, as did hedge funds, but then ran into choppy waters. If there was going to be a year in which hedge funds outperformed, this was their best opportunity. However, for the seventh straight year, investors were disappointed.

Is Hedge Fund Performance Overpriced?

Hedge fund managers are paid based on a “2 and 20” compensation structure. They earn a 2% management fee regardless of how their fund performs, and they earn a 20% performance fee paid out of profits. They are also paid bonuses irrespective of profits. This means a hedge fund with $10 billion in assets generates $20 million in income for the hedge fund firm regardless of whether it made any money for its investors. But, in recent years, hedge funds have experienced significant outflows that have put a dent in their management fee compensation. Every year, a number of hedge funds close due to poor performance or heavy outflows.

Even pension funds, which are among the largest institutional investors in hedge funds, are beginning to question the value of adding hedge funds to their portfolio, especially in light of their outsized fees. A pension fund with $50 million invested in hedge funds pays $1 million a year to have the asset managed. In comparison, an index fund that has generated better returns over the last seven years would have cost less than $100,000 per year.

Some Hedge Fund Managers Earned Their Fee in 2015

There were some winners in 2015. The top 20 hedge funds collectively generated $15 billion in profits for their investors. But, as a group, the rest of the hedge funds lost more than $95 billion for their investors. Among the better performers in 2015 were hedge funds with an Asian-Pacific focus, which averaged a 9.1% return. The volatility and relative value funds were the best-performing industry strategies with an average return of 5.5% and 5.63%, respectively. Generally, funds that limited themselves to just short or long positions underperformed because they were less reactive to the market volatility of the summer. Volatility and special opportunity strategies, such as those used in many Asia-Pacific funds, are more nimble and better equipped to make rapid changes that seize on the volatility. These hedge fund managers definitely earn their keep.

There was a time when most hedge funds earned their fee and their 20% profit. During the “lost” years of the stock market between 2000 and 2009, the average hedge fund outperformed the S&P 500 Index. Even over the last 10 years, hedge funds have delivered similar risk-adjusted returns as the S&P 500. But, after another dismal year, the question for many investors remains whether hedge funds have lost their “hedge” and are now delivering overpriced returns.

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