Is the Hedge Fund Over?

The almighty hedge fund has for a while been synonymous with lavish Wall Street lifestyles (and all its connotations, both good and bad) for several decades. But perhaps the 1990's through 2000's has been a blip on the radar.

The concept of the hedge funds date back to Alfred Winslow Jones' company, A.W. Jones & Co., which launched the first alternative investment vehicle with pooled funds in 1949.

The idea of a limited partnership vehicle making use of multiple investment strategies to control risk and a compensation system derived from performance caught on in subsequent years, with hedge funds emerging as some of the strongest investment options in the 1960s.

This period of ascendancy continued, with a few bumps as in the bear markets of the early 1970s, for decades, but it is only in the past two decades or so that hedge funds have reached a pinnacle. In November 2019, the entire hedge fund industry was valued at more than $3.61 trillion, according to the Preqin Global Hedge Fund Report.

And yet, although the number of hedge funds in existence climbed by more than 5 times between 2002 and 2015, in the last few years it has begun to appear that the era of the hedge fund is in decline. Indeed, there may even be reason to believe that hedge funds in general and as we have known them for decades are permanently over. What has changed? Where will these investors turn?

What Are Hedge Funds For?

Before we can explore how hedge funds have declined in recent years, we must first back up a step and examine what purpose hedge funds have served for investors historically. Hedge funds make use of the added investment power gained when investors pool their funds together.

A hedge fund is, put simply, an umbrella term for a financial firm that pools client assets in an effort to maximize returns. Within the world of hedge funds, there are dozens of different investment strategies, with some companies choosing to manage client assets very aggressively, others making use of leverage, and so on.

There are some hedge fund investment styles that have become sufficiently popular as to become their own subcategories in the space; the long/short equities model, for instance, is derived from A.W. Jones' first hedge fund back in the 1950s. But the breadth of investment approaches is so wide that sometimes it can be difficult to classify hedge funds in this way.

Hedge funds have traditionally also maintained several other traits which set them apart from other investment vehicles. Aside from their use of pooled funds, most hedge funds are private investment limited partnership, essentially meaning that they are open to a small number of select and accredited investors and that they have a very high investment threshold for participation. It's quite common for a hedge fund to require a minimum investment of millions of dollars.

Along with the high investment requirements, most hedge funds require that clients keep their assets in the fund for a fairly long period of time, usually at least a year. Investors agree to only withdraw their assets at particular intervals, such as once per quarter. One of the reasons for this is that hedge funds must keep a massive pool of money on hand in order to be able to perform their various investment-related tasks.

High Fees

Another long-time staple of the hedge fund industry is the fee system. Most hedge funds have traditionally operated on what is known as the "two and twenty" fee. In this fee system, clients pay a management fee of 2% of their total assets to the managers of the hedge fund.

Additionally, there is an incentive fee based on the performance of the fund. This makes up the "twenty" portion of the fee; many funds charge clients a further 20% of all returns generated on their initial investment as well. This acts as an incentive for the hedge fund managers to perform as well as possible.

All told, these traits have set hedge funds apart from most other investment vehicles for decades. Indeed, at their peak, hedge funds as a group have been unbelievably successful. It has been common for hedge funds in periods of success to generate returns in the double digits each year, far outpacing benchmarks like the S&P 500. Of course, with the possibility of outsized returns comes increased risk, too, and a good number of hedge funds have also failed. Still, the industry spent many decades generally riding out those periods of decline. So what has changed in the last few years?

Poor Returns, Investor Frustration

In the last few years in particular, hedge funds have faced new pressures. It's likely that the harm to the hedge fund reputation has come from a variety of sources; many of the top funds have struggled to provide the exceptional returns they were once capable of, investor appetite has shifted toward more passively managed opportunities like index funds and exchange-traded funds (ETFs), and so on. Hedge funds have continued to exist, with a few select firms still managing to perform extremely well. However, the industry as a whole seems to have lost some of its allure.

For as long as hedge funds thrived, there have been those in the investment world who have viewed them with skepticism at best and outright hostility at worst. Billionaire investment guru Warren Buffett has long decried hedge funds as overhyped. Indeed, in 2007 he placed a $1 million wager that a Vanguard S&P 500 Index fund would outperform a group of five hedge funds selected by a third party firm over a ten-year period.

When the end of the 10 years came about in December of 2017, he was revealed to be correct: the index fund had gained 85% in the period, while the hedge funds on aggregate gained just 22%. And that didn't even count the high cost of hedge fund fees!

Buffett's bet was a highly-publicized example of shifting investor interest which has come about for many reasons. There have always been hedge funds that have not been able to deliver on the outlandish returns promised by the industry. Typically, these funds have ended up closing.

But, on the flip side, there have also always been funds able to provide investors the unbelievable returns they have come to expect. Now, fewer and fewer funds are able to do that. And as fund performance lags, in many cases falling behind the S&P 500 benchmark, investors have grown resistant. Why wouldn't they? If they're not making as much money in hedge funds as they would in a passively managed fund, why bother? The fact that many funds retain the two and twenty fee model on top of poor returns has prompted a mass exodus of investor assets in recent years.

Money Manager Woes

Hedge fund investors are not the only ones giving up on the model. Indeed, some of the biggest names in the money management world are also growing frustrated with hedge funds.

For the hedge fund world, in which the charismatic, all-knowing, billionaire money manager is seen as a crucial indicator of success, this spells significant trouble. Increasingly, these high-profile investment leaders are giving up the hedge fund game altogether. When they do, though, they tend to continue to invest their billions of dollars, but they instead do so through what is known as a family office.

A New Model: The Family Office

A family office is effectively a personalized wealth management firm that is designed to invest a single individual's money. Stanley Druckenmiller, the billionaire leader of the successful hedge fund Duquesne, enjoyed a career of roughly 30 years with his hedge fund before giving it up in 2010.

At that time, he closed up shop and continued his investing through his own family office. At the time he decided to close down Duquesne, Druckenmiller stated that at least a portion of the reason was that he was unable to live up to his own high expectations for the hedge fund's performance.

More recently, manager Leon Cooperman of Omega Advisors closed down his hedge fund at the end of 2018. Investor assets were returned and the fund was converted into a family office for Cooperman. According to Bloomberg, Cooperman explained in a letter to clients that he didn't wish to "spend the rest of [his] life chasing the S&P 500 and focused on generating returns on investor capital." In the late 1990s, Cooperman's fund was one of the top three largest hedge funds in the world.

The Bottom Line

Is the hedge fund over? It's difficult to say. While some of the top funds have since shuttered their doors, converted into family offices, or limped along while providing underwhelming returns, it's likely that there will always be some successful hedge funds. Nonetheless, it's becoming easier all the time for hedge fund skeptics to argue that the heyday of the industry was in the past, not the present.