Death of the Hedge Fund

"When markets are trending up strongly, and there is bad news, the bad news counts for nothing. But if there is a break that reminds people what it is like to lose money in equities, then suddenly the buying is not mindless anymore. People start looking at the fundamentals, and in this case I knew the fundamentals were very ugly indeed." - A quote from Jack Schwager's book 'Hedge Fund Market Wizards'

There was recently an article publish in Bloomberg Magazine that pointed to the poor performance of hedge funds over the last few years.  The article went on to say that hedge funds are a thing of the past and that paying their exorbitant fees was ludicrous particularly when you look at their under performance compared to their mutual fund brethren.  The cover of the magazine was a man (I presume a hedge fund manager) with a graph pointing down that seemed to find its source at his crotch.  I am sure that this was not done by accident!

For decades the world has had a love hate affair with hedge funds and the managers that run them.  The fact that a number of high profile managers have made billions of dollars and spent these lavishly has not helped the hedge fund cause or image which has been portrayed as a bunch of wild men taking massive bets on market swings.  While to some extent this may be true, hedge fund managers are, as a group, considered to be some of the top investment talent in the globe.  Most of them have stellar pedigrees of trading success and have shunned the norm to create value through Alpha.

Alpha is the holy grail of investing in that it is a measure of excess return for a given level of risk.  Say for example an investment that should, based on the risk of the investment, return 6% produces 8% then the additional 2% is said to be the Alpha.  It is this Alpha that hedge funds tout as a reason for paying their high fees and these fees limit their investor base to high net worth investors.  Not only are these investors considered sophisticated, they can wait for a strategy to play out and over the years these individuals have been rewarded with massive wealth at the expense of the average investor.

The reason for their success is that hedge funds do not run with the market.  You do not make billions of dollars by betting that the market will continue in its current direction forever (which is what the majority of mutual funds do).  How the money is made is by taking bets that the cycle will end, seeing the end coming and then leveraging up to make a killing.  Now this strategy is one of many, but it is the most publicized as this is where the pain (losses) is felt and the quick money is made.  This also explains why hedge funds are under performing the markets right now - they do not expect the current market to continue and they are getting ready for the fallout.

These funds will perform magnificently well if and when the market crashes and that is why an allocation to hedge funds should be added to your portfolio.  Not keeping up with the market during good times is less of a worry and should not be a concern if the investment continues to make money when the market capitulates and this is what hedge funds offer.  Blindly throwing money into a market that is not based on solid economic fundamentals is not an investment policy followed by hedge funds.  Making and protecting their investors money during bad times is what they have been created to do and this is why an allocation to them is critical particularly when they are under performing the market as you can bet your bottom dollar that in the near future they and their investors will be laugh all the way to the bank.