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Rekenthaler Report

From the Archives: 3 Lessons From Hedge Funds' Rise and (Partial) Fall

The ups and downs each inform.

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Happy New Year! This column was originally published on May 20, 2016.

Dog Days
Hedge funds have never looked worse. Their reputation was sullied in 2008, when the average hedge fund dropped half as far as the U.S. stock market and the aggressive ones fared much worse. They then lagged during the recovery, underperforming the average balanced mutual fund for 22 out of 28 calendar quarters. Most recently, many were caught holding Valeant Pharmaceuticals.

The result, reports The Wall Street Journal, is that hedge funds face "unprecedented questions about their worth." (Sorry, the article is firewalled.) Industry stalwart Leon Cooperman called his profession "under assault." Perhaps more trouble--the world's second-largest investor in hedge funds, China Investment Corporation, has been "disappointed, to say the least," and may "slash" its hedge fund allocation.

What a change from the glory days! Three thoughts about hedge funds' ride:

Opportunities Exist(ed)
Twenty years ago, I would have scoffed at the idea that several hundred investment managers could succeed while charging their clients 2% in annual management fees, plus 20% of their funds' profits.

I would have been wrong. Although hedge fund statistics are notoriously unreliable, as hedge funds self-select when reporting their performances, there's no doubt that the industry earned its keep from the 1990s through the middle of the next decade, despite the steep expense hurdle. They prospered during the great bull market, adeptly dodged the 2000-02 descent, and then rode stocks on the rebound. Their good name was justified.

There were market quirks to be exploited--many more than I realized. Simple things like purchasing the stock of a company targeted for acquisition, if that stock is priced below the terms of the deal, while shorting the stock of the acquirer. If the merger is completed, the fund reaps a hedged profit. Or the early application of momentum research--commonly known today but not so much in the '90s--by buying stocks that have enjoyed strong recent price gains and shorting those that have been heading in the opposite direction.

More-complicated tactics, too. Hedge funds timed the technology-stock bubble, overweighting the sector as it rose through the late '90s, then exiting as the March 2000 peak approached. We know that this occurred; what puzzles is how hedge fund managers knew when to get out, leaving other investment professionals standing in the debris. They were not similarly prescient in 2008, nor at any time since then, including during last year's energy-stock tumble.

As I cannot explain why hedge funds succeeded then and are failing now, I cannot bury the business. (That the industry has grown does not suffice; size did not affect hedge funds' ability to time technology stocks in 2000 or inability to do so with energy in 2015). It is possible that today's column marks their nadir and that their decline will be no more. Thus, this first lesson is one of optimism: Sometimes, the markets surprise, by being less efficient than one expects. The case for active management is never hopeless.

Times Change
In other news, water is wet and the sky is blue. But this precept could use repeating. As I can personally attest, investment advice is best received when it implies that times do not change. Those in a stock bull market want to hear why the bull will continue, while those mired in a downturn are oddly comforted by reasons why the pain will continue. To be a hedge fund researcher in 2007 and to sound warnings about why the previous decade's success was not repeatable was to be a researcher who did not receive speaking invitations.

Yet times were changing for hedge funds. This was evident entering 2008. Many papers had shown that while stock-oriented hedge funds historically had been only partially exposed to U.S. stocks, being long in certain sectors but short in others and (yes) hedging, they looked a lot like high-cost balanced funds by the second half of the decade. Most had high correlations to the S&P 500 and fairly high betas as well.

It was, however, very difficult to convey that message. Few hedge fund managers would endorse such an argument--and investment managers who have posted strong returns have high credibility when talking about pretty much any subject. (Admit it, you upgraded your Donald Trump forecast after hearing that DoubleLine's Jeff Gundlach predicted The Donald would win The Presidency.) Arguing against hedge funds at their apex was to argue against both authority and history. It was always likely to fail.

And fail it did. In 2008, most hedge fund owners were shocked to learn that their funds had so much plain, basic stock market exposure. They should have known that already. However, they had neglected to go where the data had led.

Money Motivates?
Hedge fund managers, we are told, are better than other investment professionals because they are paid more. Their industry's very high pay, which includes the possibility of tapping directly into portfolio profits, enables hedge funds to cultivate talent that others cannot.

That is certainly true, to a point. There was a time when many top-performing mutual fund managers defected to hedge funds. Jeff Vinik, for example, left Fidelity Magellan (FMAGX) in 1996 to found a hedge fund business. Four years later, he had made so much money that he was able to shut down the hedge fund, return its money to outside investors, and focus solely on running his personal portfolio (and the portfolio of his partners). Fidelity would have paid him well--but not that well.

However, the claim that money motivates only carries so far. The argument is blatantly specious for much of human achievement, which, in areas ranging from the arts to exploration to Guinness World Record pursuits, is filled with people achieving greatness for reasons other than fiscal. Nor is it anything more than a first approximation of what makes employees happy, as any human-resources executive will attest.

Even if money does inspire, there's no guarantee that a deep desire to win will lead to victory. Are today's hedge fund managers compensated differently from those of 1998? Do they wish to make their fortunes any less? Surely the answers are no and no.

Perhaps paying an investment manager so much money that the outlay materially affects the fund's results is a necessary condition for a fund to succeed. (Unlikely, but I will not dispute the point here.) However, it certainly is not a sufficient condition. As today's hedge funds are showing, it is very possible to have tremendous incentive to triumph--yet to fail anyway.

This column's summary: Hedge funds demonstrate that opportunities exist for active managers and for their funds' investors. It is difficult to know, though, when those opportunities will cease to exist and if the active manager is overpaying himself during the pursuit. 

Postscript: Unfortunately for hedge fund investors, little has changed since this column was written, as the average hedge fund trailed Vanguard Balanced Index (VBIAX) in 2016, and then again in 2017, and then again in 2018, and then again in 2019. It likely will do so in 2020 as well. 

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

John Rekenthaler does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.