Hedge Funds Trail Stocks by the Widest Margin Since 2005
Here is the opening for this informative article from Bloomberg:
The $2.5 trillion hedge-fund industry, whose money managers are among the finance world’s highest paid, is headed for its worst annual performance relative to U.S. stocks since at least 2005.
“It has been difficult for hedge funds on the short side,” said Nick Markola, head of research at Fieldpoint Private, a $3.5 billion Greenwich, Connecticut-based private bank and wealth-advisory firm. “Funds were defensively positioned. Central bank action did bode well for equities and made for a more challenging environment for hedge funds.”
Hedge funds, which stand to earn about $50 billion in management fees this year based on industrywide assets, are underperforming the benchmark U.S. index for the fifth year in a row as the Federal Reserve’s economic stimulus program pushes equity markets higher. Billionaire Stan Druckenmiller, who produced annual returns averaging 30 percent for more than two decades, last month called the industry’s results a “tragedy” and questioned why investors pay hedge-fund fees for annual gains closer to 8 percent.
“We were expected to make 20 percent a year in any market,” Druckenmiller, 60, said in a Bloomberg Television interview on Nov. 22, referring to veteran managers such as Michael Steinhardt, Julian Robertson, Paul Tudor Jones and George Soros. “If the market went down more than 20 percent, we were expected to make more.”
The industry traditionally charges clients fees of 2 percent of assets and 20 percent of profits, sometimes with discounts for big investors. Actively managed U.S. stock mutual funds average 1.3 percent expense ratios, according to Morningstar Inc. Such managers averaged gains of 31 percent this year through last month, Morningstar said.
Hedge funds posted a 0.2 percent gain in November, according to the Bloomberg Global Aggregate Hedge Fund Index. They’ve underperformed the S&P 500 by 97 percentage points since the end of 2008. Some managers cite government intervention in markets, record low interest rates, declining trading volumes and assets moving in unison as reasons for limiting their ability to outperform.
It is a tough world out there but has the hedge fund industry peaked? Yes, in my opinion, and I maintain that it peaked near the beginning of this century.
Hedge funds charge the highest fees in the money management industry. To justify those fees, the managers need to be either very smart in terms of asset selection and timing, or lucky in terms of riding a mostly consistent long-term uptrend trend. It is not surprising that the heyday for hedge fund managers occurred during the last secular bull market of the 1980s and 1990s, and they were feted like pop stars.
Most hedge fund managers use leverage, which can be very rewarding in sharp or persistent moves. However, leverage is inevitably a double-edged sword. It also has a siren call, as anyone who uses leverage knows. If using two or three times leverage proved to be a good idea, why not leverage up ten times, or really roll the dice at a hundred times when you have the next ‘sure winner’? That is exactly what the misnamed Long-Term Capital Management did in 1998, and nearly triggered a global financial crisis before being bailed out by the Federal Reserve.
I can remember being in Bloomberg’s rather grand London Office for a short appearance on their TV programme in the late 1990s. On the way in I noticed that their large lecture lecture/presentation theatre was packed to standing room only. On inquiring, I heard that it had been hired for a series of presentations on how to set up and manage a hedge fund. That proved to be a good contrary indicator and many of those new funds were just closet trackers, charging 2 and 20.
Today, investors have far more choice. The number of comparatively low cost investment trusts (closed-end funds) has increased. Moreover, there has a large increase in the number of inexpensive exchange-traded funds (ETFs). Additionally, many more investors have decided that they can be competitive, diversified and save themselves the expense of fees by managing their own funds. The increasing number of global Autonomies, nearly 150 by FT Money’s conservative count, has made it easier to do this. Moreover, one does not need to hover over the markets every day in these sector leaders.
Lastly, and returning to the subject of leverage, here is the safest way to use it. Start with a small leveraged position relative to your capital. Do not consider increasing it, unless it is trending in your favour sufficiently so that you can sensibly protect the initial position with an in-the-money stop. Once you have increased the position, you can limit your risk by protecting it with the same stop that you are using for your initial position. If the market continues to trend in your favour, you can tighten your stop on the second position to breakeven or slightly in-the-money. Should the position continue to move in your favour, adjust the stops so that you can lock in more of the profit, while allowing the overall position sufficient breathing room for a small reaction relative to the trend you are participating in. At this stage you will also be able to increase the overall position, provided the trend remains consistent.
A market reality is that there are far more minor moves than big trending moves. Therefore, in the former instances your leveraged positions will often be stopped out for small losses or gains. However, it only takes one big trending move to provide a much more significant return. If you have been increasing positions in what turns out to be a big trend, you can continue to leverage up behind trailing stops but remember the obvious point – the only certainty is that all trends eventually end. Tactically, it is OK to hold while the trend remains consistent, provided you are following it with trailing stops to protect your accumulating profits. If the trend begins to lose consistency by clearly becoming choppier, you will know that supply and demand are moving back into balance and therefore the trend may be ending. When this happens, it would be a good idea to start taking some profits before your trailing stops are triggered. If the trend starts to accelerate, you are really on a winner and the increased consistency will enable you to tighten trailing stops. You will only need to lighten positions as acceleration becomes apparent if market liquidity is likely to be a factor. Otherwise, you can just run the position with trailing stops, and once out, stay out because acceleration is a climactic development.
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