Morgan Stanley Has Some Theories for Why Hedge Funds Are Doing So Poorly

Responsibility is lacking.
Photographer: Michael Nagle/Bloomberg

Poor performance by hedge funds continues to be a hot topic, but no one wants to take the blame for low returns. 

A survey conducted by Morgan Stanley Equity Strategist Adam Parker highlights the ostrich-like way much of the hedge fund industry is dealing with its recent inability to generate the elusive outperformance known as alpha.

"We surveyed a group of long/short fundamental equity hedge fund managers at one of the conferences, asking them for the primary reason for poor performance of their industry," he writes.

The top response received by the analyst was "crowding," or where a large number of investors are in the same trade, followed by "factor exposures," or losses based on certain risks involved in a position. 

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Last on the list was "stock selection" — a shortcoming that Parker criticized whole-heartedly.

"In other words, when performance is bad, it is beta, when performance is good, it is alpha. The truth is that 100 percent, at some level, should have said 'poor stock selection,' and what these data reveal is that 92 percent of respondents are blaming something other than their stock selection methodology for the current underperformance."

Clearly unsatisfied with the survey responses, Parker highlights some of his own reasons for poor hedge fund performance in his note.

One is simply the growth of hedge funds, which makes it harder for traders to get into positions that aren't crowded and gain an edge. Second, many firms have been extremely cautious when it comes to making sure they aren't trading on any information that might be considered "insider" following some much-publicized prosecutions. On a potentially related note, Parker points out that information is a lot easier to find in this day and age, making it harder for firms to get an edge on a trade. Even the lack of initial public offerings is hurting hedge funds, as the easy money that was once available in quick trades of newly public companies in the 1990s is hard to find when nobody wants to go public (though it might still be alive in the corporate bond market). 

While Parker doesn't think hedge funds are in for a rapid improvement, though there are signs of a potential turnaround. 

"When will excess performance be likely again? Our suspicion is that much wider dispersion is required, and this isn’t likely until long-dated [interest] rates back up meaningfully or economic volatility grows materially. That said, dispersion is clearly wider than it was a year ago, and active management has yet to enjoy an improvement in performance. Here’s hoping that later this year we won’t need any excuses, due to good stock selection."

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