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3 Lessons From Hedge Funds’ Rise and (Partial) Fall

The ups and downs each inform.

John Rekenthaler, 05/20/2016

Dog Days
Hedge funds have never looked worse. Their reputation was sullied in 2008, when the average hedge fund dropped half as far as the U.S. stock market and the aggressive ones fared much worse. They then lagged during the recovery, underperforming the average balanced mutual fund for 22 out of 28 calendar quarters. Most recently, many were caught holding Valeant Pharmaceuticals VRX.

The result, reports The Wall Street Journal, is that hedge funds face “unprecedented questions about their worth.” (Sorry, the article is firewalled.) Industry stalwart Leon Cooperman called his profession “under assault.” Perhaps more trouble--the world’s second-largest investor in hedge funds, China Investment Corporation, has been “disappointed, to say the least,” and may “slash” its hedge fund allocation.

What a change from the glory days! Three thoughts about hedge funds’ ride--

Opportunities Exist(ed)
Twenty years ago, I would have scoffed at the idea that several hundred investment managers could succeed while charging their clients 2% in annual management fees, plus 20% of their funds’ profits.

I would have been wrong. Although hedge fund statistics are notoriously unreliable, as hedge funds self-select when reporting their performances, there’s no doubt that the industry earned its keep from the '90s through the middle of the next decade, despite the steep expense hurdle. They prospered during the great bull market, adeptly dodged the 2000-02 descent, and then rode stocks on the rebound. Their good name was justified.

There were market quirks to be exploited--many more than I realized. Simple things like purchasing the stock of a company targeted for acquisition, if that stock is priced below the terms of the deal, while shorting the stock of the acquirer. If the merger is completed, the fund reaps a hedged profit. Or the early application of momentum research--commonly known today but not so much in the '90s--by buying stocks that have enjoyed strong recent price gains and shorting those that have been heading in the opposite direction.

More-complicated tactics, too. Hedge funds timed the technology-stock bubble, overweighting the sector as it rose through the late '90s, then exiting as the March 2000 peak approached. We know that this occurred; what puzzles is how hedge fund managers knew when to get out, leaving other investment professionals standing in the debris. They were not similarly prescient in 2008, nor at any time since then, including during last year’s energy-stock tumble.

As I cannot explain why hedge funds succeeded then and are failing now, I cannot bury the business. (That the industry has grown does not suffice; size did not affect hedge funds’ ability to time technology stocks in 2000 or inability to do so with energy in 2015). It is possible that today’s column marks their nadir and that their decline will be no more. Thus, this first lesson is one of optimism: Sometimes, the markets surprise, by being less efficient than one expects. The case for active management is never hopeless.

is vice president of research for Morningstar.

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