markets

Greg Blotnick – MarketWatch – Hedge Funds

Opinion: Investors are dumping hedge funds just when they’re needed most – Greg Blotnick

Hedge funds today are about as welcome as a stick in the eye.

Endowment funds and pension funds are reducing allocations en masse in favor of indexing and private equity, as outflows reach levels unseen since the financial crisis. Harvard University plans to fire half of its endowment staff and shut down its internal hedge funds amid underperformance.

While some of the disdain is deserved, there are a handful of misconceptions about hedge funds — particularly long/short equity — among the media and investors that are worth clearing up. The key takeaway is that redemptions are rising just as hedge funds are well-positioned to outperform. Long/short funds use leverage, derivatives and short positions in an attempt to make money in any market condition.

Hedge funds have been around since Alfred W. Jones first hung a shingle in 1952, but their popularity (as measured by assets under management) picked up in the 1980s and accelerated after the Nasdaq COMP, +0.15%  bubble popped in 2000. The zeitgeist of the era, as well as the “secular vs. cyclical” debate, is captured in historical articles by Forbes and our very own Wall Street Journal.

In the late 1990s, sentiment was poor following Long-Term Capital Management’s collapse in 1998 and became exacerbated as many funds underperformed during the meteoric stock market rise of 1999. A cyclical bottom was marked as industry patriarch Julian Robertson closed Tiger Management in 2000 — which was the second-largest hedge fund only three years earlier — just months before equities collapsed.

Also read: Nouriel Roubini’s Trump’s erratic, destructive policies could tank the markets and Victor Reklaitis’ Dan Loeb’s playbook for investment home runs in the Trump era

Long/short funds, as one would expect, trounced the market over the following few years, delivering 16% returns in 2000 with the S&P 500 SPX, +0.07%  down 9%, 5% returns with the S&P 500 down 12%, and minus 2% returns with the S&P 500 down 22%.

Sentiment began to shift, with the WSJ remarking in mid-2002: “Both the Dow industrials and the Nasdaq fell to fresh lows Friday, and given the performance, investors are hunting for places to put their money where it won’t evaporate. Hedge funds, on the surface, seem like a natural choice, given that they’ve outperformed the market for the last two years.” The industry’s assets under management grew 38%.

Three months later, the Journal noted: “Hedge funds are viewed as a way of making money even when stock prices are in decline, making them particularly attractive to some investors now.” A similar dynamic played out after 2008 as long/short equity funds returned minus 12%, lower than the S&P 500’s minus 37%.

So even professional investors and allocators suffer from recency bias — people most easily remember something that has happened recently — and think to add downside protection only after a stock market crash. We are seeing the inverse of that today.

In this long bull market — which turns eight years old next month — hedge funds by nature will underperform, yet investors continue to benchmark performance as upside capture versus the S&P 500 — which is a misunderstanding of how most long/short funds operate. The product writ large is designed to reduce a diversified portfolio’s correlation to the market, lower standard deviation (thus increasing a portfolio’s Sharpe ratio) and ultimately deliver long-term returns in excess of the market. Investors today are redeeming money from long/short funds when those investments are likely to be needed most.

Greg Blotnick is a long/short equity analyst at a private investment firm covering consumer, TMT and industrial stocks. Blotnick has spent his career in the asset-management industry and served as a fundamental analyst for former multi-billion dollar hedge funds. He holds an MBA from Columbia Business School and is a CFA charter holder. Follow him on Twitter at @Greg_Blotnick.

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