Equity-oriented hedge funds have lagged the market by a wide margin during its decade-long bull run, prompting three straight years of net withdrawals by investors, the longest such period of outflows since 1990, per data from research firm HFR Inc. cited in a detailed report by The Wall Street Journal. As a result, many of these funds, including some of previously stellar reputations and star managers, are being forced to close.

From 1990 through 2009, equity-focused hedge funds produced an average annual total return that beat the S&P 500 Index by more than 5 percentage points. From 2010 onwards, however, they have trailed the index by more than 9 percentage points annually, on average. “Investors are frustrated,” as Greg Dowling of Fund Evaluation Group, an investment consulting firm, told the Journal. “Clients expect them to underperform in a raging bull market, but not by a huge degree, for years on end," he added.

Key Takeaways

  • Hedge funds have been big laggards during the bull market.
  • Investors are withdrawing money, and funds are closing.
  • The number of hedge funds has risen dramatically.
  • Fees are under pressure.

Significance for Investors

In the first half of 2019, hedge funds continued to be laggards. While the S&P 500 returned 18.5%, the average hedge fund had a net return of just 7.2%, according to data from BarclayHedge cited in another Journal report. So-called "equity long bias funds," which offer largely unhedged exposure to stocks, did the best, though they only returned 10.6% on average.

A recent casualty is Jeff Vinik, who succeeded the legendary Peter Lynch as manager of the Fidelity Magellan Fund in 1990. Vinik later became a hedge fund manager, closed his fund in 2013, but reopened it in 2019. He looked to raise $3 billion in two months, but attracted only $465 million. Last week, he decided to quit again.

“What I learned after probably 75 meetings is the hedge fund industry of 2019 is very different than the hedge fund industry when I started in 1996, and it’s even very different from the hedge fund industry when I closed in 2013,” Vinik said. Rapidly rising competition is one problem. The number of hedge funds has exploded from 530 in 1990 to 8,200 today, with their aggregate assets under management (AUM) skyrocketing from $39 billion to $3.2 trillion.

Fees are under pressure. These traditionally have been 2% of AUM per year, plus 20% of any investment gains. A growing number of hedge funds now feel compelled to charge less. By contrast, the three largest ETFs that track the S&P 500 have annual expense ratios ranging from 0.03% to 0.09%.

Another issue is the rapid growth of quantitative investing and passive investing. The former quickly exploits pricing anomalies ahead of human hedge fund managers. The latter has helped to create a market in which stocks are increasingly correlated. The proportion of stock trading performed by human stock pickers has fallen from about 45% in the late 1990s to only about 15% today, per research by JPMorgan Chase & Co.

Looking Ahead

Despite net redemptions of $23 billion during the first half of 2019, total hedge fund assets rose to a record $3.25 trillion, up from $3.1 trillion at the start of the year, per data from Hedge Fund Research reported by the Journal. While performance was subpar, it was more than enough to offset net withdrawals of funds. However, continued underperformance is bound to send yet more investors to the exits.