It's been a terrible six months for hedge funds, so bad that Third Point said in a letter on Tuesday that some strategies had become "a hedge fund killing field."
The pain has been particularly severe for so-called market neutral funds, which seek positive returns regardless of the direction of broad stock or bond indexes. These suffered so much because there were too many such funds without enough ideas. And a bunch of their collectively popular trades blew up in their faces.
Third Point described performance generally as "catastrophic," and the firm is girding for a "washout" among hedge funds that'll likely provide investment opportunities for the survivors (including itself).
This market has been particularly difficult to navigate, in large part because of central bank intervention from every corner of the globe. When the Federal Reserve was the main game in town, investors could predict that more monetary easing would fuel bond and stock values. But that's much more difficult now that European and Japanese central bankers are racing to catch up with the U.S., unleashing ever more experimental policies. This has resulted in some unpredictable moves in currencies.
For example, many funds bet on an acceleration in China's economic decline, which doesn't seem to have happened yet. After the yuan declined earlier in the year against the dollar, it has stabilized, going against fund managers' predictions of a gigantic, messy devaluation. Growth in the nation has slowed but is still relatively high compared with developed economies. Its credit bubble hasn't popped yet, even if it appears to be deflating just a touch.
Second, there's a limited scope of big bets that larger hedge funds can make right now. Either they need to wager on broad trends that require more luck than skill to get right, or they need to lock their money up with specific risky companies where high value may just as easily translate into enormous losses.
Unfortunately for many funds, their corporate bets were not so great this year or even downright terrible. Shares of Valeant, for example, which is a top holding of billionaire Bill Ackman, have plunged more than 60 percent this year. Those who bet on the Pfizer-Allergan merger were crushed when the deal fell apart earlier this month.
Hedge funds plowed into SunEdison, owning more than half of the solar company's shares last year, only to suffer big losses this year as it filed for bankruptcy.
Hedge funds posted their worst performance since 2008 in the first three months of 2016 while the broad-based indexes that these funds sought to avoid, such as the S&P 500 and the Barclays Global Aggregate Corporate Bond index, generated returns of 1.3 percent and 4.6 percent respectively.
Investors are taking note and withdrawing cash from hedge funds that once promised them immunity from market swoons. Brevan Howard's investors have asked to pull about $1.4 billion from the firm’s main hedge fund, sources told Sabrina Willmer and Nishant Kumar. Assets at Prosiris Capital Management, the hedge fund founded by Goldman Sachs alumnus Reza Ali, have tumbled by almost 40 percent in less than a year.
Perhaps there's a bigger lesson to be drawn from this year's "killing field" -- fund managers don't have some secret recipe for returns. Either managers need to have specific views on broader markets or a clear methodology for how to select long-term value investments. Claiming neutrality is a poor substitute for lacking conviction.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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