Despite market uncertainty, the S&P 500 is at an all time high. In fact, most indexes are trending up as the financial world recovers from the panic over the Brexit vote. Despite these generally positive indicators, one class of investments is not performing well: hedge funds.
Hedge funds are struggling to produce returns that match their more conservative whole-market fund counterparts. Leading figures in investment at Third Point, for example, lost 2.3% while the S&P whole market index gained 1.3% How, despite the expert management, are these funds doing so poorly?
First, there are material explanations. Hedge funds seek undervalued companies as opportunities for growth. These are very risky acquisitions. In times of financial uncertainty, investors tend to be incredibly risk averse, which drives capital away from emerging markets. No capital movement means no winners and losers, which means hedge fund gains are hamstrung from the gate.
Second, this sector invests heavily in emerging markets in foreign countries, particularly in Asian and African markets. Growth in China has not kept pace with projections, as that country is facing a demographic problem. The working age population is shrinking, and living conditions are not strong enough to attract immigration. Growth in African markets has been curtailed by uncertainty in the currency market. When established economies suffer currency corrections, developing economies suffer from an interruption to their supply of credit. The dollar experienced such a correction after the 2008 recession, and the pound is currently experiencing major problems on the ForEx market. This currency uncertainty is creating problems in emerging markets, which hurts hedge funds’ primary source of growth.
Third, there is a human resources problem. In order to attract top talent, manager compensation has escalated astronomically, especially at the large firms which set the pace for the rest of the industry. In order to compete with low-cost index funds, hedge funds must outstrip them in performance by a huge margin. Beating the market is a daunting task under normal circumstances. Beating the market while spotting it several hundred thousand dollars in fees and compensation is next to impossible, especially in such a crowded labor market.
Individual investors need to remember what they’re investing for. If a get-rich-quick opportunity is the real desire, lottery tickets are cheaper than devoting a significant portion of a retirement to high-risk, high-return investments. Value, both in terms of likely future returns and manageable fees, should be the the drivers for disciplined investors.