Hedge fund managers have the potential to earn much larger fees than other investment managers do. The two and twenty compensation structure allows the best-performing managers to earn hundreds of millions to billions of dollars in fees when they make big profits for their clients. However, when hedge fund returns barely surpass or even lag benchmarks, such as the Standard and Poor's (S&P) 500 Index, critics attack the two and twenty structure by saying that it unfairly rewards managers.

From 2011 to 2015, average annual hedge fund returns of 1.7% lagged far behind average annual returns of 11% for the S&P 500 Index. The Barclays Hedge Fund Index, which measures the average return of all hedge funds, generated year-to-date (YTD) returns of 0.76% through the end of May 2016, compared to 2.59% for the S&P 500 Index. The rally in equities that began in early February 2016 exacerbated the disparity between hedge fund and market performance. Some observers wonder whether hedge funds might overweight equities in the second half of 2016 to catch up with equity market returns.

Hedge Funds Trail Equities

The turmoil in commodity and international markets at the beginning of 2016 led hedge funds to reduce their exposure to equities by 8.7% at the start of the second quarter, which was the largest reduction since 2011. At the same time, hedge funds increased their short positions. As the rally in stocks gained steam in the second quarter of 2016, the spread between S&P 500 Index returns and hedge fund returns grew larger. On June 6, 2016, returns on the Hedge Fund Research Index, which is another measurement of hedge fund performances, trailed returns on the S&P 500 by the widest margin at any point in 2016.

Investors Remain Sidelined

The reduction in long positions and increase in short bets left hedge funds too hedged and not long enough. Nicholas Colas, chief market strategist at Convergex Group LLC, believes that hedge funds may trade out of short positions and reallocate assets into less crowded and potentially more profitable long positions. A continuation of the equity rally in the second half of 2016 would give hedge funds a chance to boost their returns.

However, hedge funds are not the only investing class that missed the rally in the second quarter of 2016. Mutual funds raised cash levels, and retail investors were absent during the rally. In fact, corporations, which repurchased $165 billion of their own shares, accounted for virtually all of the buying in the second quarter of 2016.

Playing Catch-Up

The underperformance of hedge funds and mutual funds relative to the S&P 500 Index may bode well for equities in the second half of 2016. Money managers likely feel pressure to buy stocks in order to bring their performance in line with the benchmark index. At the end of the first quarter of 2016, hedge funds owned only 5.4% of shares of companies in the Russell 3000 Index. Second-quarter data may show that funds increased their exposure to this index.

Hedge funds must overweight their equity holdings to catch up with benchmark indexes. Neil Azous, founder of Rareview Macro LLC, noted that there are two ways that hedge funds could equal or surpass equity market returns: hedge funds could remain underinvested if equity markets plummet, or hedge funds could use leverage to outperform equity market gains.

Big Bets on Momentum

Data from May 2016 SEC Form 13F filings shows that hedge funds are aggressively reallocating their assets into momentum stocks, which are stocks that have performed the best over recent history. Research from the Goldman Sachs Group Inc. (NYSE: GS) shows that hedge funds are concentrating their bets in fewer names. Hedge funds hold a greater percentage of their assets in their top 10 holdings than at any point on record.

How momentum stocks perform in the rest of 2016 may determine the fate of many hedge fund managers. If hedge funds continue to underperform, it could lead to a wave of redemptions from investors. However, if hedge funds outperform, it could signal a rebirth for the industry.

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