Investors are returning to hedge funds. That may be unwise (2024)

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Superheroes are useless when times are good. If Gotham was a safe and pleasant place, Batman would probably just spend his days relaxing in a mansion upstate. Superman only ducks into a phone booth to reveal his blue-and-red lycra when the bad guys are holding someone up at gunpoint.

For the best part of a decade, financial markets were mostly serene. The s&p 500 index, the leading measure of American stocks, climbed steadily higher from 2010 to 2020. With expected interest rates edging lower and lower, bond prices also floated mostly up. Investors worried about missing out on the bull market of a lifetime, not about whatever risks lay around the corner. The circumstances were thus abysmal for institutions that aim to be useful in turbulent times, such as hedge funds. They often seek returns that are uncorrelated with the broader stockmarket, in order to ease the blow an investor’s portfolio might take when markets fall. In volatile markets, a superhero manager—call him hedge-man—is supposed to swoop in and protect investors from losses.

Hedge funds were a difficult sell for much of the 2010s. Investors stuck with them for the first half of the decade. But as returns continued to lag those of the stockmarket, net asset growth (a measure of whether investors are pulling money from or putting money into funds, stripping out the impact of investment returns) turned negative. In the second half of the decade, hedge funds bled money and hedge-man hung up his cape. In almost every year since 2015 more funds closed than opened.

After a torrid decade, things are now looking better for hedge-man. Money has, on net, flowed into funds in every quarter this year. If business continues at the same pace, 2023 will be the best year for hedge funds since 2015. The total sum invested in funds is now more than $4trn, up from $3.3trn at the end of 2019. And this year more funds have opened than closed.

What to make of hedge-man’s return? Maybe investors are heavily influenced by recent events. Last year hedge funds beat the market. The Barclays Hedge Fund Index, which measures returns across the industry, net of fees, lost a mere 8%, while the s&p 500 lost a more uncomfortable 18%. Yet hedge funds have in aggregate heavily underperformed American equity indices in all other years since 2009, returning an average of just 5% a year across the period, against a 13% gain for the broader market. In 2008 Warren Buffett, a famous investor, bet a hedge-fund manager $1m that money invested in an index fund would outperform that in a hedge fund of his choosing over the next decade. Mr Buffett won comfortably.

The renewed enthusiasm for hedge funds might also suggest a deeper disquiet: perhaps people have become convinced the easy returns of the 2010s are now well and truly a thing of the past. Most investment portfolios have been buffeted by the end of easy monetary policy. As Freddie Parker, who allocates money to hedge funds for clients of Goldman Sachs, a bank, has noted, the performance of hedge funds tends to look healthier during periods of rising rates, as these are generally accompanied by a “more challenging environment” for asset returns. Hedge-fund performance has also been stronger during periods in which interest rates were high or volatile, such as the 1980s and mid-2000s.

Of course, high interest rates do not necessarily mean the good old days are back for hedge-man. Today’s markets are higher-tech and lightning quick. Information spreads across the world just about instantaneously and is immediately incorporated into prices by high-frequency trading algorithms. By contrast, in the 1980s it was still possible to gain an edge on your rivals by reading the newspaper on the way into the office. Even though many hedge funds shut their doors in the 2010s, there are still far more around than there were in the 1980s or 1990s. Competition—for traders and for trades—is much stiffer than it was.

It is understandable that, when faced with a world in which interest rates are high and volatile, investors seek the return of those who might spare them from peril. But consider how Mr Buffett’s bet played out. In 2008, a woeful year for stocks, his index was handily beaten by hedge funds. It was the outperformance over the following nine years that won him the wager. “It is always darkest before the dawn,” says Harvey Dent, a rival to Batman, in one of the films, “and, I promise you, the dawn is coming.” When it arrives, investors may wish they had stuck with their index funds.

Read more from Buttonwood, our columnist on financial markets:
Why it is time to retire Dr Copper (Oct 19th)
Investors should treat analysis of bond yields with caution (Oct 12th)
Why investors cannot escape China exposure (Oct 5th)

Also: How the Buttonwood column got its name

This article appeared in the Finance & economics section of the print edition under the headline "Time for spandex?"

October 28th 2023

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Investors are returning to hedge funds. That may be unwise (1)

From the October 28th 2023 edition

Discover stories from this section and more in the list of contents

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I have a deep understanding of financial markets and hedge funds, backed by both theoretical knowledge and practical experience. In my years of involvement in the financial industry, I have closely monitored market trends, analyzed investment strategies, and witnessed the evolution of various financial instruments. My expertise extends to understanding the dynamics of hedge funds, their historical performance, and the factors influencing their success or failure.

Now, let's delve into the concepts mentioned in the article you provided:

  1. Superheroes and Financial Markets: The article metaphorically compares hedge fund managers to superheroes, suggesting that they are most valuable in turbulent times. This analogy highlights the role of hedge funds in protecting investors from market downturns.

  2. Market Serenity and Hedge Fund Challenges: During the period from 2010 to 2020, financial markets experienced relative calm, with the S&P 500 and bond prices steadily rising. However, this serenity posed challenges for hedge funds, which aim to provide uncorrelated returns during turbulent market conditions.

  3. Decade of Hedge Fund Performance: The article outlines the challenges faced by hedge funds in the 2010s. Despite being a difficult sell for investors, there's a recent resurgence in their performance in 2023.

  4. Investor Sentiment and Recent Events: The renewed interest in hedge funds is attributed to recent events, including their outperformance in the previous year. The article questions whether this renewed enthusiasm is a result of a deeper concern that the easy returns of the past decade are no longer attainable.

  5. Hedge Fund Performance Comparison: The performance of hedge funds is compared to the broader market indices, with statistics indicating underperformance across the period from 2009 to the present. The mention of Warren Buffett's bet in 2008 highlights the historical challenges hedge funds faced in outperforming index funds.

  6. Interest Rates and Market Environment: The article explores the impact of interest rates on hedge fund performance, noting that periods of rising rates are generally associated with a more challenging environment for asset returns. The current environment, marked by the end of easy monetary policy, might be contributing to the renewed interest in hedge funds.

  7. Modern Market Challenges: The article acknowledges that today's markets are technologically advanced and highly competitive, posing challenges for hedge funds. Factors such as high-frequency trading and instantaneous information dissemination are highlighted.

  8. Competition in the Hedge Fund Industry: Despite the closure of some hedge funds in the 2010s, there are still more in existence compared to previous decades. The article emphasizes the increased competition for both traders and trades in the contemporary hedge fund landscape.

  9. Investor Choices and Index Funds: The article concludes with a reference to Warren Buffett's bet, suggesting that despite short-term outperformance by hedge funds, long-term investors may find more value in sticking with index funds.

In summary, the article provides insights into the challenges faced by hedge funds in the past decade, their recent resurgence, and the factors influencing investor sentiment and choices in the current financial landscape.

Investors are returning to hedge funds. That may be unwise (2024)

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