Eagle Daily Investor

Why Did Hedge Funds Underperform Last Year?

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It was another embarrassing year for Wall Street’s “Masters of the Universe.” According to HFR, the average hedge fund investing in stocks gained 15% in 2013. Across all strategies, hedge funds returned an average 9.3%. Global Macro investing — the granddaddy of all hedge fund strategies — had yet another subpar year, losing 0.3% on average.

However you slice and dice it, it is egg on the face of the entire industry. By simply being “dumb and long,” the S&P 500 made 32%.

2013: It Was Not a Good Year

For hedge fund managers raised on the mother’s milk of diversification and trend following, 2013 was one of the worst years on record, compared to simple “long-only” strategies.

Bridgewater Associates, led by the quirky Ray Dalio, the world’s biggest hedge-fund firm with $150 billion in assets under management, had its second embarrassing year in a row.

Bridgwater’s flagship “Pure Alpha” fund generated a mere 5.3%. Its “All Weather” fund lost 3.9% — in year when the financial weather really wasn’t all that bad. European rival Brevan Howard saw its “Master Fund” rise less than 1%.

Trend-following hedge funds also continued their string of bad luck. Cantab’s flagship “CCP Quantitative” fund finished the year down 27.7%. Bluecrest’s “Bluetrend” fund was down 8.7% as of November.

2013: The Strategies that Worked

It is easy to play Monday morning quarterback with hedge-fund strategies.

After all, with the benefit of 20/20 hindsight, there always is an investment strategy that would have made you look like a genius.

This year, the world’s top hedge funds didn’t make money by employing the sophisticated Rube Goldberg-style strategies of the quants or the prescient predictions of global macro managers.

They made money by sticking to the best-performing stock markets — in the United States and Japan — and betting on a few high-flying stocks and sectors.

And if you really wanted to knock the ball out of the park, all you had to do was leverage those bets.

In my trading services this past year, I regularly recommended leveraged bets on U.S. small caps and biotech.

Here’s how you would have done, had you stuck with, say, a leveraged bet on booming biotech through ProShares Ultra Nasdaq Biotechnology (BIB), a position I still currently hold.

 BIB_011414

Sure enough, it was similar strategies — and having the tenacity to ride out the pullbacks — that made those managing billions of dollars in hedge-fund money look smart as well.

Take Boston-based Whale Rock Capital Management. This fund rose 53% on bets that included Netflix Inc., LinkedIn Corp., Pandora Media Inc. and Chinese software company Qihoo 360 Technology Co. Ltd.

But frankly, you could have gotten any of these recommendations by subscribing to a handful of financial newsletters for a couple of hundred dollars a year.

Activist investors were also big winners in 2013.

Glenview Capital Management rose 43%, and Trian Fund Management posted a 40% increase. But they all paled in comparison to Carl Icahn’s publicly traded partnership — and current Alpha Investor Letter recommendation — Icahn Investment Partners (IEP) — which blew all rivals out of the water with a gain of 154.83% in 2013.

Hedge-Fund Underperformance: The Elephant in the Room

Engaging Schadenfreude — taking pleasure at the misfortune of hedge-fund types — may make you feel good, of course.

But put that on hold for a minute, and let’s try to explain why some of the smartest, most dedicated folks on the planet can seem to get to grips with the financial markets — despite seemingly endless computing resources, theoretical physics PhDs, as well as street-smart-trader types fighting in their corner.

Of course, there are always idiosyncratic reasons for why hedge funds underperform.

For example, global macro investors diversify risk among stocks, bonds and commodities. But this year, all of these asset classes suffered after the Federal Reserve hinted at a reduction in its stimulus efforts in May, even as a single asset class — the U.S. stock market — rallied hard.

And what you invest in still determines how much money you make more than how well you invest. It is easy to be a genius when everything in your sector is going up — and to confuse brains with a bull market.

I think the elephant in the room is that the hedge-fund world has become too institutionalized.

And, with a few exceptions, that has sucked the big gains out of the entire hedge- fund sector.

Hedge funds have been transformed from “cowboys” into financially emasculated “alpha-generating” financial instruments. And their biggest clients are risk-averse pension funds whose directors go almost apoplectic at the thought having to endure any volatility.

So a hedge fund that invests in strategies like ProShares Ultra Nasdaq Biotechnology (BIB) simply would never get off the ground, no matter how much money it makes.

Pension funds actually pull money out of hedge funds for doing too well. After all, that signifies it took on too much risk. And from a pension fund’s perspective, that view may be right.

Contrast that with the days of yore.

In 1992, George Soros advised his chief investment officer Stan Druckenmiller to up his bet against the pound sterling with the words, “It takes courage to be a pig!”

If the portfolio manager responsible for hedge funds at the California Public Employees’ Retirement System (Calpers) would catch wind of that story today, she would pull Calpers’ money from Soros immediately.

That’s why today’s big hedge funds take very little risk. That, in turn, explains their consistently anemic returns.

“It’s kind of a tragedy,” reflected a pensive Druckenmiller, during a November interview with Bloomberg Television.

“We were expected to make 20% a year in any market,” Druckenmiller said. He himself achieved an annualized return of 30% before retiring to manage only his own money in 2010.

So I don’t expect huge returns from the hedge fund sector in the years ahead.

To make money, you have to take risks.

That’s just the way financial markets work on Planet Earth.

In case you missed it, I encourage you to read my e-letter column from last week about why market sentiment is leaving me bullish. I also invite you to comment in the space provided below.

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About Nicholas Vardy

Nicholas Vardy is currently Editor of The Global Guru, a free weekly e-newsletter, and a monthly investment newsletter, The Alpha Investor Letter, which provides longer-term global investments. He also writes two weekly trading services, Triple Digit Trader and Bull Market Alert, which focus on making short-term profits in the hottest markets in the world. A former mutual fund money manager, he is also chief investment officer of Global Guru Capital LLC, where he manages separate accounts for high net worth individuals. A graduate of Stanford University and the Harvard University Law School, he has a unique background that has proven his knack for making money in different markets around the world. He also is a chartered financial analyst.

View all posts by Nicholas Vardy →

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