Why 2014 is Another Lousy Year for Hedge Funds

Even as the S&P 500 flirts with the 2,000 level, up a solid 7.71% through the first eight months of 2014, the hedge fund industry is enduring yet another difficult year.

Once renowned for risk-loving “cowboy” trading and double-digit percentage returns, hedge funds have failed to live up to their reputation as money-making machines.

Hedge Funds: Trailing the Market in 2014, Yet Again

According to data compiler Preqin, hedge funds have trailed Standard & Poor’s 500 stock index in 2014, both through the end of July, as well as over the past 12 months. Year-to-date through July, the Preqin Hedge Fund All Strategies benchmark posted a gain of 3.47%. That’s far below the 4.45% gain for the S&P 500 over the same period.

Other observers of the hedge fund world confirm this underperformance. The Barclay Hedge Fund Index is up 3.26% through end of July, while Hedge Fund Research pegs the average hedge fund return at just 2.5% over the first seven months of the year.

Preqin also notes that hedge funds underperformed the broad U.S. stock market over the past 12 months. Having rallied 14.5% over the past year, the S&P 500 outpaced the Preqin Hedge Fund All Strategies benchmark by more than 5%. Perhaps most surprisingly, not a single one of the 19 major hedge fund strategies tracked by Preqin have beaten the S&P 500.

Nor is the picture any better across the pond. The $492 billion Europe-focused hedge fund industry generated a return of 2.1% in the first half of 2014. That is less than one-third of the 6.7% return of the benchmark STOXX Europe 600 Index. As Barbara Wall, Europe research director at Cerulli Associates points out, hedge funds last outperformed European stocks in 2008, when hedge funds fell 17.4% and the STOXX Europe 600 slumped 43%.

Hedge Fund Investors: Increasingly Disaffected

Looking at this underperformance, no wonder some institutional investors have cut back or even completely axed their investment in hedge funds.

The disaffected group includes $300 billion mega pension fund California Public Employees’ Retirement System (CALPERS); the $18.3 billion Los Angeles Fire & Police Pension System; and even the $2.7 billion Oxfordshire County Council, Oxford, England; all of which have reduced their hedge fund investments.

The Market Claims Its Scalps

Up until 2008, hedge funds had a fantastic run. Since then, making money in the markets has become markedly more difficult. The big hedge fund managers achieved most of their big returns before 2008. Since the market bottomed in March 2009, almost all the big names have lost their way.

It’s no surprise that the past few years have claimed their share of prominent hedge fund scalps. Several top-notch hedge fund managers, including George Soros and the United Kingdom’s Anthony Bolton, have thrown in the towel.

And it’s not like the money managers who have stayed in the game are exactly hitting the cover off of the ball, either. Louis Bacon returned $2 billion to his investors in 2012 after conceding he was confounded by the markets.

At times like this, it’s natural to want to move the goal posts. Analysts point out that hedge funds are not necessarily designed to outperform a broad market index like the S&P 500. Instead, hedge funds are designed to generate “risk-adjusted returns” as measured by obscure measures like Sharpe and Sortino ratios.

Yet with the S&P 500 now close to tripling since it bottomed in March 2009, you’d think a monkey throwing darts at a Wall Street Journal would have made more money than George Soros has.

And you’d probably be right…

Hedge Funds Are Struggling: Here’s Why

So why has the financial environment confounded the biggest brains in finance and lagged the overall market?

First, most hedge funds charge a management fee of 2% on assets under management. In addition, they normally receive 20% of all fund profits. That compares with the 0.05% charged by the Vanguard S&P 500 ETF (VOO). The high-fee structure is a huge millstone around the neck of hedge funds.

Second, the investment environment since 2008 has been disorienting. Hedge funds have had to assess the impact of government intervention, quantitative easing, record low interest rates, constant pressure from regulators and a fall in volatility. All of these factors have hampered hedge funds’ ability to deliver big returns.

Third, thanks to the Internet, there has been a remarkable democratization of information. You now have access to infinitely more information on your iPhone than George Soros did at the height of his powers in the 1990s. It’s much harder to get — and keep — an edge in today’s markets.

Finally, there is the changed relationship hedge funds have to risk. Hedge funds are focused on the downside to a degree it’s hard for most investors to imagine. At SAC Capital, before it folded after several scandals, if a portfolio manager was down 5%, she lost half of her money under management. If she lost 10%, she was shown the door. Apply that same standard to your favorite broker, and see how long he’d last.

After a paradigm-shifting 2008, hedge funds are “once bitten, twice shy.” They are (rightly) focused on the downside risks — whether financial contagion from a Russian invasion of Ukraine or another “Black Swan” event which they cannot predict.

Is It Worth Betting on Hedge Funds?

For sellers of index funds, “buy and hold” remains the dominant investment mantra.

And for retail investors, staying “dumb and long” in the U.S. stock market, while ignoring the dips, has been the single investment strategy that has trounced hedge funds since March of 2009.

Whether that is likely to change is unclear. And perhaps the next “Black Swan” event will allow hedge funds to prove their mettle.

But it’s hard not to think that patience with hedge funds is running out.

In case you missed it, I encourage you to read my e-letter column from last week about whether or not we are on the verge of a market crash. I also invite you to comment in the space provided below.