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Hedge funds — there are too many of them and most of them are lousy

Julia La Roche
Reporter
Fictional hedge fund manager Bobby Axelrod (Image: Showtime, IMDB)

The uproar against the hedge fund industry has become almost deafening in recent weeks.

There’s going to be a “washout in hedge funds.”

There’s a “lack of talent.”

And those fees that they charge are “unbelievable”!

All of these statements are fair for the most part.

That said, it’s really not fair to paint entire industry with the same brush. Not all hedge funds are bad.

'Too Many Players'

Perhaps the real issue here is that there are just too many hedge funds, with most unable to deliver the performance they advertise.

There are more than 10,000 hedge funds. By some estimates, there are as many as 15,000 hedge funds.

Speaking at the Milken Global Institute Conference, Steve Cohen, who runs $11 billion family office Point72 Asset Management (formerly SAC Capital), said there are “too many players.”

“Well that’s something actually I was worried about last year. I actually had a meeting with my management team and I was talking about how one of my biggest worries is that there’s so many players out there trying to do similar strategies and if one of these highly levered players had a rough run and took down risk would we be collateral damage?” Cohen said.

He later added: “And in February we drew down 8%, which, for us, is a lot. And my worst fears were realized. So yeah, I think the business has gotten crowded. The strategies aren’t that much differentiated. People seem to think they can just go hire talent and magically they’re going to earn returns…and they’re trying to grow…It’s very hard to maximize returns and maximize assets too."

Steven Cohen. Photographer: Simon Dawson/Bloomberg

Cohen added that “talent is very thin” and that he’s “blown away by the lack of talent.”

While Cohen is referring to recruiting—which is facing challenges such as shrinking investment banking classes and more young workers heading to Silicon Valley—it does resonate with the hedge fund industry as a whole.

Not everyone is cut out for this business. Indeed, only a small percentage are superior at generating alpha.

And the funds that aren't delivering alpha aren't just underperforming. Many are getting smoked.

'Catastrophic' Performance

In late April, Daniel Loeb, the founder of Third Point LLC, sent a letter to his fund’s investors calling the first quarter “one of the most catastrophic periods of hedge fund performance” he’s witnessed in his twenty years running his hedge fund. Third Point, which has produced annualized returns of 15.8% since inception, fell 2.3% in the first quarter.

Loeb wrote: “There is no doubt that we are in the first innings of a washout in hedge funds and certain strategies.”

The average hedge fund fell 0.67% in the first quarter, according to data from Hedge Fund Research. While that number might not look “catastrophic” on the surface, it’s certainly not great.

During the first quarter, there was also significant dispersion in returns amongst hedge fund managers. If you just glance at the top performers versus the bottom performers, the range of returns are very wide. Some funds are up more than 20% while others are down 20%.

Redemptions are ramping up

Poor performance tends to be followed by investors pulling funds.

“Those managers that underperformed are going to sustain significant redemptions,” Don Steinbrugge, managing partner of the Richmond, Virginia-based Agecroft Partners, a marketing and consulting firm for the hedge fund industry, said. “I think you will see the number of closures go up.”

He predicted that money going to come out of the managers that significantly underperformed their peers.

During a volatile first quarter, investors pulled $15.1 billion in capital from hedge funds, making it the largest quarterly outflow since the second quarter of 2009, according to a recent report from Hedge Fund Research.

That’s a relatively small amount considering the hedge fund industry manages a little less than $3 trillion in assets. The industry had also seen positive inflows for almost every quarter since 2009.

“The hedge fund industry did lose $15 billion, but that’s only half of one percent. If they lost that every quarter for the next two years they would only lose 4%. It’s not very noticeable,” Steinbrugge said.

Steinbrugge also said that some of that money is being recirculated to either managers who performed well or the money is shifting to strategies that are uncorrelated to the capital markets.

The 'unbelievable' Fees

The poor performance tends to reignite the age-old debate about hedge fund fees. Typically, fund managers are paid through a compensation structure commonly known as the "2 and 20," which means they charge investors 2% of total assets under management and 20% of any profits. The fees can vary from fund to fund, with some charging less and others charging more. "3 and 30" is becoming phrase in the industry.

Warren Buffett. Photographer: Daniel Acker/Bloomberg

At the Berkshire Hathaway Annual Meeting, billionaire investor Warren Buffett, who has long been critical of hedge fund compensation, slammed the industry for their fees.

“A 2 and 20 arrangement with Berkshire, which is not uncommon in the hedge-fund world ... they would be getting $180 million each, you know, merely for breathing, annually. That it's a compensation scheme is unbelievable to me.”

At the Milken Global Investment Conference, the CalSTRS chief investment officer Christopher Ailman declared to CNBC that 2 and 20 is “dead.”

“The standard fee that hedge funds charge has come down slightly,” Steinbrugge said. “The way it’s coming down is new funds being launched are more frequently charging 1.5% and 20. Hedge funds aren’t changing their standard fees—they’re not going it not their operating documents and lowering fees for current investors.”

That said, most hedge funds will negotiate fees for large mandates. A large investor like CalSTRS should be able to negotiate fees, Steinbrugge said.

‘Just Hang On Tight'

Amid the criticism of funds, Larry Robbins, the founder of Glenview Capital, defended the industry at the Sohn Investment Conference on Wednesday in front on nearly 3,000 investors.

“It sounds like hedge funds have been playing dodgeball,” Robbins said. “In the week alone, [Warren] Buffett criticized hedge funds, members of the [Milken Global Investment Conference] criticized hedge funds. Even hedge funds criticized hedge funds. I don’t know what happens after this— Harry Caray doesn’t like the Cubs or maybe mom and apple pie get in a fight or I don’t like hockey or food or something like that.”

Larry Robbins, Founder, Portfolio Manager and CEO, Glenview Capital Management LLC., speaks at the Sohn Investment Conference in New York City, U.S. May 4, 2016. REUTERS/Brendan McDermid

Robbins analogized what’s been happening to tubing behind a boat. He suggested that investors “hang on tight” and not get caught up in the waves of fear and uncertainty.

Glenview is down 9.88% this year after ending 2015 down 18.12%. The fund has produced annualized returns of 11.56% since its inception in December 2000, HSBC data shows.

'No Other Alternatives'

While most hedge fund investors are disappointed, and justifiably so, there just aren’t many other attractive alternatives for them to invest in this current low-return environment.

These days, most of these large institutional investors are only expecting a 4% to 7% annual return, which should outperform the typical fixed income portfolio, Steinbrugge noted. He pointed out that most of the allocations from pension funds have been to equities.

“And they should have a large allocation, but it shouldn’t be too be too big because equity markets can go down a lot and they can stay down a lot longer. In 1929, the equity market went down peak to trough almost 90 percent. It didn’t get back until 1953,” Steinbrugge said.

“Hedge funds hopefully will have two benefits — adding return to the portfolio and the other is reducing volatility and downside risk to the portfolio."

He said a lot of them learned that lesson during the financial crisis.

"In 2008, a lot of pensions learned they weren’t as diversified.,” Steinbrugge said. "Markets go down, correlations go up. In 2008, the world monetary authorities injected tremendous amounts of liquidity into their economies."

All of this speaks an underappreciated side of the hedge fund debate: demand. Demand from pensions, other institutional investors, and other accredited investors are the reasons why so many hedge funds exist. While the hedge fund industry is providing the supply, it's also up to the investors to do their homework as they assume this non-traditional risk.

Indeed, the markets shouldn't always expect to be saved by policymakers every time things go south.

"If we have another 2008 situation, there’s just not a lot of dry powder for monetary authorities to stimulate in the market and it could last a lot longer,” Steinbrugge said.

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Julia La Roche is a finance reporter at Yahoo Finance.

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