Before they discovered hedge funds, pension funds and school and foundation endowments typically held portfolios with 60 percent in equities and 40 percent in bonds. Many would be better off if they had stuck with that formula. Hedge funds have trailed both the Standard & Poor’s 500-stock index and a Vanguard index fund with the 60/40 mix over the past five years, according to data compiled by Bloomberg. “People hear about the top-performing hedge funds, and they assume those results hold true for the whole industry,” says George Sauter, chief investment officer for Vanguard Group. “It turns out that, on average, hedge funds are about average.”
Investors are still drawn to hedge funds by the returns of top managers such as Paul Singer of Elliott Management and Seth Klarman of Baupost Group. Total hedge fund assets reached $2.1 trillion as of March 31, more than four times their level in 2000, data from Hedge Fund Research show. That’s making it difficult for the hedge fund industry to produce better results than other asset classes, says Simon Lack, a former executive at JPMorgan Chase and author of the 2012 book The Hedge Fund Mirage. “You have more money chasing fewer opportunities,” he says.
The main Bloomberg hedge fund index, which tracks 2,697 funds, fell 2.2 percent a year in the five years ended June 30. The Vanguard Balanced Index Fund, which has a 60/40 split of equities and bonds, gained 3.5 percent annually, and the S&P 500 gained 0.2 percent a year. The Vanguard fund has also beaten the HFRX Global Hedge Fund Index, a measure of hedge fund performance with a longer history, every year since 2003.
Investors still expect hedge funds to outperform in the long run as low bond yields and a slow-growing global economy limit the gains from stocks and bonds, says Don Steinbrugge, managing partner of Agecroft Partners, which advises hedge funds and investors. He adds that hedge funds have boosted returns and protected investors in difficult markets. From the end of 2000 through 2002, when the S&P 500 fell an annualized 17 percent and the Vanguard fund lost 6.3 percent, hedge funds returned 6.7 percent, according to HFRX data.
The hedge fund industry’s recent underperformance has contributed to an estimated $4 trillion in unfunded liabilities at U.S. pension funds. Joseph Dear, the investment chief of the $238 billion CalPERS, the pension fund for California public employees, said in May that he wasn’t willing to pay hedge fund managers the standard fee of 2 percent of assets and 20 percent of profits if they don’t beat the market. Holland Timmins, chief investment officer of the $25 billion Texas Permanent School Fund, said in January that the fund’s returns were being “eaten alive” by hedge fund fees.
David Swensen, the chief investment officer of Yale University’s $19.4 billion endowment, speaking at a Bloomberg conference in January, said hedge funds’ traditional fees “are a huge issue” and are unmerited except for funds that deliver extraordinary performance.
The best hedge fund managers have outperformed the S&P 500 over long stretches of time. Elliott Management, which has $20 billion in assets, returned 14 percent a year, compared with 11 percent for the index since 1977, according to the firm. The fund has had nine losing quarters in its 35-year history. Klarman, founder of Boston-based Baupost, which manages $24 billion, returned 18 percent a year since 1983. The S&P 500 gained about 10 percent annually during that period.
Among investors stuck with a less stellar manager, unhappiness over the mismatch between fees and performance is growing, says Chris Vogt, who managed hedge fund investments for Allstate before moving to Margaret A. Cargill Philanthropies in July. “There is going to be more and more pressure on those who haven’t consistently performed,” he says. “If we have another flat year of performance, fees are going to have to come down.”