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Hedge Funds, Past and Future

Barry Ritholtz is a Bloomberg View columnist. He founded Ritholtz Wealth Management and was chief executive and director of equity research at FusionIQ, a quantitative research firm. He blogs at the Big Picture and is the author of “Bailout Nation: How Greed and Easy Money Corrupted Wall Street and Shook the World Economy.”
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This has turned out to be a year of milestones for the hedge-fund industry. It is a tale we have chronicled all year. As markets barrel into the end of the fourth quarter, it's worth reviewing the highlights from this year to see if we can deduce what might be in store for the 2&20 crowd in 2015.

The good news -- at least for the fund managers -- is that hedge funds continue to attract assets. The latest read is $2.82 trillion under management spread among almost 10,000 funds, according to HFR Hedge Fund Industry Reports.

The bad news? “Hedge funds are shutting at a rate not seen since the financial crisis,” according to a report earlier this month from Bloomberg News. The prime culprit is underperformance. Data compiled by Bloomberg show that as of Dec. 1, across all hedge funds, returns have been a mere 2 percent. It is the worst performance for the industry since 2011.

Part of the problem is in the skewed distribution of returns. Rather than the normal Gaussian distribution typically observed in smooth bell curves, it is feast or famine. A handful of top–performers are capturing the lion’s share of alpha, or market-beating returns, leaving the rest of the industry with scraps.

Darwin’s laws of the jungle apply to capital as well: The big get bigger, while the weak atrophy and eventually die out. The elite firms dominate money raising.

None of this is new. As we noted last December, “the $2.5 trillion hedge-fund industry, whose money managers are among the finance world’s highest paid, is headed for its worst annual performance relative to U.S. stocks since at least 2005.

The reasons for this underperformance aren't a mystery. We detailed many of the causes previously (see "The High Cost of Neuro-Financial Errors: How Cognitive Bias and Performance Chasing leads to Investing Failures," a presentation I made at the John F. Kennedy School of Government at Harvard University).

Perhaps the more intriguing question is why so many investors are attracted to hedge funds in the first place. Some of it is due to cognitive issues. Perhaps the dynamism of managers is exciting; there is also a lottery-like nature of getting on board with the next high-alpha generator.

Regardless, although the best 10-year track records are obvious, selecting the emerging managers of the next 10 years has proven to be impossible.

These were among the many factors that led CalPERS, the nation's biggest public-pension fund, to drop hedge funds from its investment strategy. In addition to the cost and performance issues, the complexity of selecting, monitoring and managing hedge funds had become problematic for the $300 billion retirement fund.  

We have yet to see the full impact of that decision, which will affect everything from asset gathering to money management.

The big public-pension funds today have two major models to follow: CalPERS and Yale. Very few funds seem to be able to achieve what Yale’s endowment accomplished under David Swensen. But Yale had the huge advantage of being first, when alpha generation was high, costs were reasonable and valuations modest.

Here is an easy prediction for 2015: We will see more feast or famine for the industry, with a handful of firms capturing most of the alpha and fresh assets. More firms will shut their doors. Perhaps a few more endowments and pension funds will re-evaluate their hedge-fund investments. Don’t be surprised if venture-capital and private-equity fund are next to undergo a similar examination.

Previously:

The Five Reasons Hedge Funds Underperform

The Hedge-Fund Manager Dilemma 

Why Investors Love Hedge Funds 

Hedge-Fund Guys and Their Stock Tips  

Getting Over Hedge Funds

California Earthquake for Hedge Funds

Harvard Should Copy Calpers, Not Yale

Why Hedge With a Hedge Fund?  

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Barry L Ritholtz at britholtz3@bloomberg.net

To contact the editor on this story:
James Greiff at jgreiff@bloomberg.net