The industry has underperformed the stock and bond markets as a whole, resulting in massive withdrawals by their investors. Big-name public pension funds from California to New York City have said they are bailing out completely.
“Everybody believes in their own mystique,” said John C. “Jack” Bogle, founder of Vanguard Group and arch-critic of managed investment vehicles like hedge funds. “There’s so much luck in this business. I find it very hard to believe in most mystiques.”
More than 80 percent of investors redeemed at least a portion of their money from hedge funds in the first half of 2016, according to a study by Credit Suisse Capital Services. Underperformance by specific hedge fund managers was responsible for 53 percent of those redemptions, according to the study.
Tudor Investment Corp., founded by Paul Tudor Jones and one of the oldest hedge funds, dismissed about 15 percent of the workforce after more than $2 billion in investor withdrawals this year, Bloomberg reported recently. Brevan Howard Asset Management last year cut 50 jobs because of losses.
More industry withdrawals are likely. The Credit Suisse study, which polled 209 investors representing $700 billion in hedge fund allocations, said 61 percent of those respondents plan to redeem money in the last six months of 2016.
“It’s not surprising. They [investors] all have different thresholds for making decisions on their redemptions and allocations,” said Robert Leonard, global head of capital services at Credit Suisse.
Bogle, 87, called me from his Vanguard office at Valley Forge, Pa., on Wednesday to discuss the hedge-fund redemptions, which he attributes to a surge of competition in the sector and the inevitable “reversion to the mean” for returns.
What is a hedge fund? I call it a loose term for a pool of money run by a fund manager who tends to make up or down bets, sometimes both at the same time, on stocks, bonds, currencies and commodities. Hedge funds can be complex and riskier than what retail investors know, and often rely on mathematicians and quantitative experts — “quants.”
“It’s a very shifting crowd,” Bogle said of their investing strategy. (Shifting, not shifty.) “The style is very aggressive investing. Large positions.”
The industry is known for its big fees and big bets. John Paulson rose to legend-status when he earned a reported $4 billion betting against subprime mortgages during the financial crisis.
Institutions tend to participate in hedge funds as a way to diversify their portfolio and reduce volatility.
Hedge funds enjoyed a heyday for several years from 1993 to the financial crash of 2007, earning outsized returns of 12.7 percent annually after fees, according to Hedge Fund Research.
“Compare that to the balanced index fund [a broad-based portfolio made up of 60 percent stocks and 40 percent bonds], which had a return of 9 percent, net of fees. That is a difference of 3.7 percent over 14 years. The difference is really quite large,” Bogle said.
Advantage, hedge fund.
Rich people were the first to invest in hedge funds, but now the customer base is dominated by institutions. Think pension funds sitting on tens and hundreds of billions of dollars. Many are under pressure to produce annual returns of 7.5 percent on their portfolios.
“That’s an insane assumption,” said Bogle, adding that stocks and bonds alone cannot perform that well over coming decades. “So [pensions] have to reach for a higher return. They go to these hedge funds, most of whom are quite brilliant.”
Then came the financial crisis of 2007-08.
“Since 2007, we had a big market decline. Hedge funds didn’t do much beginning in 2008, and have had a very slow comeback. From 2008 to 2016, hedge funds have averaged 2.5 percent. And the balanced index fund has averaged 6.6 percent.”
Advantage, index funds.
According to a report in the Financial Times, the number of hedge funds increased from 3,102 funds managing $465 billion in 2000 to 8,474 funds managing just under $3 trillion in 2016, mostly for pensions and foundations.
“They can’t win because they are competing against each other,” said Bogle. Back in 1993, “people with good ideas could implement them. We are now are at a stage… where markets get more and more efficient.
“The business gets much tougher to distinguish yourself. You have a lot of competition. Lot of smart people. They have very high IQs. But if everybody has a high IQ, it’s tough to distinguish yourself.”
Leonard, from Credit Suisse, said it may get a bit worse before it gets better for hedge funds.
“I would not be surprised to see additional fund closures,” Leonard said. But he said the current bull market in stocks may be nearing its end, which means people might look elsewhere for returns – and back toward hedge funds.
“We are entering a period where hedge funds can play a very important role.”
Bogle is sticking with index funds.
“There is an innate tendency of reversion to the mean. If you are way above average, you will go back to the average. It’s the way marketplaces work. No one should be surprised at the great advantage hedge funds had for 14 or 15 years. No one should have expected that to continue. Investors are very foolish. We think that past is prologue, and it’s not.”