Yes, yes, everyone knows hedge funds aren't benchmarked to the S&P - after all they "hedge" for the broader market downside.
Here is the problem: having underperformed the S&P for five years in a row [14], many LPs are starting to get tired of not only underperforming stocks but paying out 2 and 20 on all the lost upside (and not only due to such leftfield surprises as RICO Stevie [15]).
The bigger problem is that by the time the crash finally comes, there will be no hedges left as the Federal Reserve will have made sure all shorts get crushed as confirmed by the relentless outperformance of the most shorted stocks [16]relative to the market (and why we continue to suggest quarter [17]after quarter that [18]going long the most shorted stocks is the most lucrative "alpha" strategy) as "hedge" funds abandon all hedging in droves and become "long-onlies", a problem further compounded by the fact that when the real crash does come not one hedge fund will be positioned properly and able to generate any alpha.
The biggest problem, at least for the active management community, is that with the global central banks now stock market activists and buying stocks outright [19], it is they who have eliminated the downside risk and by implication made hedging redundant.
So for all those curious why all real money managers (and not those who spend 18 hours a day on the modern day Yahoo Finance known as Twitter, "trading" with monopoly money while selling $29.95 newsletters) are furious at what Bernanke and company are doing as shown in the most recent Ira Sohn conference, we present the chart below from Goldman which confirms what most have already known: the Federal Reserve has made hedge funds a thing of the past, whose investors are sure to keep underperforming the S&P until the moment when it all goes tumbling down.
[20]
Luckily, at that point, bidless market aside, everyone will be able to sell ahead of everyone else, or so the momentum-chasing mantra goes. In the meantime the facts are sobering: the average hedge fund has returned a tiny 5.4% through the week of May 10, a whopping 65% discount to the performance of the S&P, and even the average mutual fund has outperformed the average hedge fund nearly threefold!
Some more from Goldman:
- The typical hedge fund generated a YTD return of 5% through May 10, compared with 15% gains for both the S&P 500 and the average large-cap core mutual fund (see Exhibit 1). Hedge funds returned an average of 3.5% in 1Q 2013, lagging the S&P 500 by 700 bp. Last year the average fund returned 8% vs. 16% for the S&P 500.
- The distribution of YTD performance indicates that 13% of hedge funds have generated absolute losses. The standard deviation of YTD hedge fund returns is 6 percentage points and almost half of funds have generated returns between 3 % and 8%. Fewer than 5% of funds have outperformed the S&P 500 or the average large-cap core mutual fund YTD.
- Despite starting the year with the highest net long exposure since 1Q 2007, strong long performance was not enough to outweigh the drag from popular short positions. Our basket of S&P 500 stocks with the largest dollars of shorts (<GSTHVISP>) has returned 17% YTD, in line with the VIP basket. In addition, 22 of the 50 stocks over $1 billion with the highest short interest as a percentage of market cap returned over 30%, twice the S&P 500 return. The average return of these 50 stocks was also 30%.
As for that key "benefit" from hedge funds - diversification away from single-name holdings - they were only kidding. In fact the average hedge fund is nearly twice more undiversified than the average mutual fund, and just 10 names represent 63% of the average hedge fund's AUM. See AAPL for what happens when said hedge fund hotels fall out of favor.
"Hedge fund returns are highly dependent on the performance of a few key stocks. The typical hedge fund has an average of 63% of its long-equity assets invested in its 10 largest positions compared with 37% for the typical large-cap mutual fund, 16% for a small-cap mutual fund, 18% for the S&P 500 and just 3% for the Russell 2000 Index."
[21]
Finally, for those wondering who is selling one share of SPY or GLD for every share bought? Wonder no more: ETFs continue to be the widest used hedging vehicle:
- Hedge funds appear to use ETFs more as a hedging tool than as a directional investment vehicle, based on our analysis of 13-F and short interest filings. We estimate that hedge funds hold $126 billion in gross exposure to ETFs compared with $1.4 trillion of gross exposure to single-stocks. ETFs represent 3% of long holdings, down from nearly 6% in 1Q 2009 and the lowest since 2Q 2011 levels (Exhibit 22).
- The $96 billion of short ETF positions accounts for 76% of the hedge fund gross ETF exposure. In contrast, single-stock short positions ($406 billion) represent 29% of hedge fund gross single-stock positions. The most shorted ETFs tend to be index hedges (representing $50 billion of the $96 billion short positions). Commodity-related, bond funds, and Emerging Market ETFs appear to make up the majority of ETFs that hedge funds utilize on the long side (see Exhibit 23).
[22]
Source: Goldman