It has been a rough few years for many hedge funds, and 2018 offered no respite. High fees and mediocre returns have put fund managers in the hot seat as never before. Going into 2019, they have a lot to prove and, so far, have actually done fairly well. While still lagging the S&P 500 Index as a group, hedge funds are at least comfortably in the black.
With that being said, hedge funds have a whole lot of work to do to win back the interest of increasingly skeptical allocators and investors.
Bruised in 2018
The whipsawing volatility and specter of a potential economic reversal sent markets into a tailspin in the last weeks of 2018. Hedge funds, traditionally thought to do well in such times (hence, the term “hedge” in the name), turned in a rather lackluster performance as a group. Indeed, they underperformed the stock market quite badly, with funds overly concentrated in a few securities suffering especially badly.
Not all funds lost, of course. Macro strategies, for example, proved to be one of the few winners in 2018. One such fund, Bridgewater’s flagship Pure Alpha Fund, turned in an impressive 14.6% gain net of fees.
Yet, while Ray Dalio’s (Trades, Portfolio) fund may have bucked the trend, it was certainly a rare exception. Even the most respected hedge fund gurus were not spared the pain. The legendary David Einhorn (Trades, Portfolio) turned in his worst year ever. Daniel Loeb (Trades, Portfolio) ended up with double-digit losses after a disastrous December.
Bouncing back
Given their battering last year, hedge funds have been put under the microscope by allocators and investors. So there has likely been a sigh of relief within the industry so far this year. In the first two months of 2019, hedge funds have made big gains. In fact, it is the industry’s strongest start since 2012.
According to the latest report from Hedge Fund Research, all of the principal strategies it tracks are up since the start of the year. Collectively, they are up 4.9% on a fund-weighted basis through February. That has more than erased the losses of 2018, when funds lost 4.1%.
All hedge fund strategies have done well so far, but the equity hedge strategy has seen particular ebullience. Funds running this strategy have posted a 7% gain for the first two months of 2019.
Braking in February
Hedge funds continue to gain ground in February, but their returns proved less impressive than those in January. As a group, funds gained 1.4%, a significant slowdown from January’s strong start. Up 1.8%, the equity hedge strategy was the top performer for the month.
In a sideways market, these returns might be considered impressive. Unfortunately for fund managers, that has not been the case. Indeed, the S&P 500 index has outpaced hedge funds in spite of their historically strong start. The broad index is up 7.8% through February (closer to 11% if we include 100% dividend reinvestment).
The year is far from over, but these are hardly excellent signs for the vaunted hedge fund industry’s hopes of proving their worth to their limited partners.
But some earn their keep
Of course, not all funds are created equal. As investors know all too well, there are many funds out there that make a few bad calls and get pasted. That has a tendency to drag down aggregate industry performance, clouding the potential outperformance of some of the best fund managers.
Sure, the S&P 500 is currently ahead of hedge funds overall in the first two months of 2019. But if we consider only the best funds, the story changes substantially. The funds ranked by Hedge Fund Research in the top decile of performance are well ahead of the index. In February alone, these top funds saw gains of 7%.
Built to last?
In a research note published early this year, we advised extreme caution to anyone considering an allocation to a hedge fund:
“Investors thinking about allocating to hedge funds (or trying to emulate a hedge fund strategy) should be especially wary, since hedge fund performance in 2018 was actually better than it might otherwise have been. While diversified strategies, such as macro funds, did fairly well for the whole year, they were down substantially during the final quarter. Indeed, all major hedge fund categories were down during the fourth quarter.”
After getting pasted in the fourth quarter of 2018, some resurgence was to be expected. Furthermore, posting gains when the stock market is also gaining is far from exciting.
That hedge funds continue lag the stock market is an ominous sign for an industry that has justified enormous fees on the basis it can produce market-beating returns.
Verdict
Hedge funds have managed not to lose money in 2019 so far, but that is hardly a recommendation in their favor. Overall, allocating to hedge funds still looks like a risky - and expensive - play. And that holds even if one manages to pick a particularly strong performer.
Investors are still probably best served doing their own research and making their own decisions.
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