Equity-oriented hedge funds have lagged the market by a wide margin during its decade-long bull run, prompting three straight years of net withdrawals by investors, the longest such period of outflows since 1990, per data from research firm HFR Inc. cited in a detailed report by The Wall Street Journal. As a result, many of these funds, including some of previously stellar reputations and star managers, are being forced to close.

From 1990 through 2009, equity-focused hedge funds produced an average annual total return that beat the S&P 500 Index by more than 5 percentage points. From 2010 onwards, however, they have trailed the index by more than 9 percentage points annually, on average. “Investors are frustrated,” as Greg Dowling of Fund Evaluation Group, an investment consulting firm, told the Journal. “Clients expect them to underperform in a raging bull market, but not by a huge degree, for years on end," he added.

Key Takeaways

  • Despite their hype and allure, hedge funds have actually been big laggards during the bull market of the past decade.
  • Aside from lower returns, high fees and barriers to exit also present challenges to investors.
  • As a result, investors are withdrawing money, and funds are closing shop.

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Lagging Performance

In 2019, hedge funds continued to be laggards. While the S&P 500 returned around 30%, the average hedge fund had a net return of just 17.2%, according to data from BarclayHedge cited in another Journal report. So-called "equity long bias funds," which offer largely unhedged exposure to stocks, did the best, though they only returned 20.6% on average.

A recent casualty is Jeff Vinik, who succeeded the legendary Peter Lynch as manager of the Fidelity Magellan Fund in 1990. Vinik later became a hedge fund manager, closed his fund in 2013, but reopened it in 2019. He looked to raise $3 billion in two months, but attracted only $465 million. In October 2019, he decided to quit 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,” Vinik said. Rapidly rising competition is one problem. The number of hedge funds has exploded from 530 in 1990 to 8,200 today, with their aggregate assets under management (AUM) skyrocketing from $39 billion to $3.2 trillion.

High Fees

Fees are under pressure. These traditionally have been 2% of AUM per year, plus 20% of any investment gains - a fee structure known as "two and twenty". A growing number of hedge funds now feel compelled to charge less. By contrast, the three largest ETFs that track the S&P 500 have annual expense ratios ranging from 0.03% to 0.09%.

Another issue is the rapid growth of quantitative investing and passive investing. The former quickly exploits pricing anomalies ahead of human hedge fund managers. The latter has helped to create a market in which stocks are increasingly correlated. The proportion of stock trading performed by human stock pickers has fallen from about 45% in the late 1990s to only about 15% today, per research by JPMorgan Chase & Co.

Illiquid Funds

Another problem with hedge funds is that many of them lock up investor money for relatively long periods of time. In other words, an investor cannot redeem (withdraw) their money until a number of months or years has passed, even if the fund fails to perform. This makes hedge funds an illiquid product, which can be a real problem in an economic downturn when cash on hand is needed, providing a barrier to exit.

For hedge funds, the lock-up period is intended to give the hedge fund manager time to establish their strategy and exit investments in an orderly fashion. Hedge fund lock-ups are typically 30-90 days, giving the hedge fund manager time to exit investments without driving prices against their overall portfolio, but may also extend to a year or more.

The Bottom Line

Despite net redemptions of $23 billion during the first half of 2019, total hedge fund assets rose to a record $3.25 trillion, up from $3.1 trillion at the start of the year, per data from Hedge Fund Research reported by the Journal. While performance was subpar, it was more than enough to offset net withdrawals of funds. However, continued underperformance is bound to send yet more investors to the exits.