Fallen Idols

Hedge Funds No Longer Need the Star System

Despite the travails of celebrated managers, the industry is doing fine.
Photographers: Andrew Harrer (Einhorn); Patrick T. Fallon (Ackman)/Bloomberg

Hedge funds’ brightest lights have fallen on hard times, but don’t shed a tear for the industry just yet.    

The list of once-revered-now-humbled hedge fund managers is growing. Alan Fournier is shutting Pennant Capital Management after nearly two decades, acknowledging that “recent returns have been disappointing.” David Einhorn’s main hedge fund at Greenlight Capital was down 14 percent in the first quarter  after a decline of 4.1 percent annually from 2015 to 2017. Pershing Square Capital Management’s Bill Ackman called his recent returns “particularly unsatisfactory,” and investors apparently agree. Ackman’s assets under management shrank to $8.2 billion as of March from $18.3 billion in 2015.

Despite the travails of star managers, however, the hedge fund industry is doing fine. The HFRI Fund Weighted Composite Index returned 0.3 percent during the first quarter, compared with a negative 0.8 percent for the S&P 500 Index, including dividends.

Granted, hedge funds haven’t kept pace with the stock market in recent years, but they’ve fared better than many of the stars among them. The HFRI index has returned 4 percent annually from 2015 through March, compared with 10.2 percent for the S&P 500.

Blistering Pace

Hedge funds' recent returns have been overshadowed by the stock market's stellar performance

Sources: Bloomberg, author's calculations

More important, the industry has retained its faithful following. Investors poured a net $284 billion into hedge funds from 2010 to 2017, according to HFR, and total assets were at a record $3.2 trillion as of the end of 2017.  

What Problem?

Despite lackluster performance, hedge fund assets are at a record high

Source: HFR

Still, the recent stumbles of the industry’s most celebrated managers are a turning point that hedgies should heed. Mutual funds have been through this, and their experience is instructive.

Like hedge funds, the mutual fund industry was once dominated by star managers. Investors worshipped stock and bond pickers such as Peter Lynch, Bill Miller and Bill Gross for obvious reasons -- and paid them accordingly.  

Under Peter Lynch, Fidelity’s Magellan Fund returned 29.1 percent annually from May 1977 to May 1990, besting the S&P 500 by an astonishing 13.4 percentage points a year. Bill Miller’s Legg Mason Value Trust beat the S&P 500 for 15 consecutive years from 1991 to 2005, outpacing the index by 4.9 percentage points annually during that period. And bond manager Bill Gross beat the Bloomberg Barclays U.S. Aggregate Bond Index by 1 percentage point annually during his 27 years as manager of the Pimco Total Return Fund -- a huge margin of victory for a bond manager.

But the market eventually turns on most managers. Sure, a few like Lynch manage to walk away before then. Most, however, will encounter periods when their style of investing simply isn’t working.   

It happened to Miller and Gross. After Miller’s 15-year win streak, his Value Trust returned a negative 5.1 percent annually from January 2006 until his tenure ended in April 2012, while the S&P 500 returned 4 percent a year. And Gross has struggled to recreate his old magic. His Janus Henderson Global Unconstrained Bond Fund has lagged the aggregate bond index by 0.2 percentage points annually since he took the reins in September 2014 through March.

Manager, Interrupted

Bill Miller's value style of investing has been out of favor since the 2008 financial crisis

Sources: Bloomberg, author's calculations

Over time, it has become increasingly clear to investors that even the best mutual fund managers aren’t gods but merely artisans plying their investment strategies. Miller’s strategy was value -- buying cheap stocks. Lynch’s was a combination of quality and value -- buying highly profitable and well-capitalized companies for a reasonable price. Those strategies work great, until they don’t.   

Which raises inevitable questions: Are fund managers overpaid, and are there ways to execute their strategies more cheaply? 

The answer to both is yes. There’s a new generation of so-called smart beta mutual funds and exchange-traded funds that replicate investing styles used by Lynch, Miller, Gross and others. They’re cheaper, more transparent and increasingly popular with investors. Smart beta ETFs have taken in $319 billion since 2013 through Tuesday, compared with just $128 billion from 2006 to 2012, according to Bloomberg Intelligence.

Quants Are Coming

Investors have increasingly embraced quantitative active management, or smart beta, in recent years

Source: Bloomberg Intelligence

Note: 2018 flows through March.

Investors will soon ask similar questions about hedge funds. There are already several dozen ETFs that replicate hedge fund strategies such as long-short equity, market neutral and arbitrage. It’s early days, but more will undoubtedly follow, and they’ll become better and cheaper with time.

Like mutual fund managers, hedgies aren’t going away any time soon. But the cult of star hedge fund managers is dying, and the opacity and high cost of hedge funds will follow.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

    To contact the author of this story:
    Nir Kaissar in New York at nkaissar1@bloomberg.net

    To contact the editor responsible for this story:
    Daniel Niemi at dniemi1@bloomberg.net

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