Wolf Richter: Investors Dump Hedge Funds Due to Lousy Performance, High Fees

Yves here. I was remiss in not writing up an important story yesterday, on how hedge funds are finally getting long-overdue pushback from investors on the lousy connection between fees and performance. We flagged this issue in our very first post in 2006. CalPERS admitted back then that hedge funds were not delivering any performance premium, despite the lavish fees. The giant pension fund rationalized staying in the strategy because it believed that hedge funds nevertheless provided returns that weren’t closely tied to stock market returns. We pointed out then that that was no justification for paying the lofty “2 and 20” (2% management, 20% carry fees) because you could construct that type of exposure, or hedge, much more cheaply, as hedge fund clones were staring to do.

The investment rationale for hedge funds has only gotten worse. Since 2012, hedge fund returns have become more correlated with the stock market, reducing its diversification benefit. Typical hedge fund returns have by many measures undershot equity market returns. And marquee funds, like Paulson & Company, Greenlight Capital, and Pershing Square, have badly underperformed, savaging the myth that institutional investors might tell themselves, if only they’d been more exposed to the really hot funds….

By Wolf Richter, a San Francisco based executive, entrepreneur, start up specialist, and author, with extensive international work experience. Originally published at Wolf Street

The wrath of investors: worst capital outflows since 2009.

Big public pension funds are slow-moving apparatuses. So dramatic shifts in investment decisions take a long time to be discussed and decided, and even longer before they’re felt by the investment community. But now they’re being felt – painfully.

In September 2014, the $300-billion California Public Employees’ Retirement System, the nation’s largest pension fund, announced that it would liquidate over the following year its investments totaling $4 billion in 24 hedge funds and six funds-of-funds; they were too complicated and too expensive.

Calpers interim CIO Ted Eliopoulos said at the time that, “at the end of the day, when judged against their complexity, cost and the lack of ability to scale at Calpers’ size,” the hedge fund program “doesn’t merit a continued role.”

And this ended pension funds’ post-financial-crisis love affair with hedge funds.

Hedge funds were supposed to help pension funds fill in their funding holes with higher returns. They were supposed to help pension funds fulfill their lofty promises to the retirees. Instead, hedge funds have deepened those holes with below-par returns – and some with spectacular losses. And to make the bitter fare go down better, they’ve decorated it with dizzying fees.

Calpers is the model for many pension funds. And its decision soon began to reverberate through the industry. Other pension funds chimed in. For example, last Thursday, the New York City Employees Retirement System voted to liquidated its entire $1.5 billion hedge fund program, a trustee told Reuters, “as soon as practicable in an orderly and prudent manner.”

Letitia James, public advocate for NYCERS, lambasted hedge funds for their “exorbitant fees” and lashed out at managers who “balk at negotiations for investor-favorable terms,” thinking they “could do no wrong, even as they are losing money.”

“If they were truly fiduciaries and cared about our members, they would never charge large fees for failing to deliver on their promises,” she told the Financial Times. “Let them sell their summer homes and jets, and return those fees to their investors.”

Hope, lousy returns, and high fees. A toxic mix.

And those fees are big: 2% of assets plus most commonly, for the lucky ones, 20% of profits. If these profits aren’t substantial, it’s a prescription for investor frustration.

Pension funds weren’t the only ones. The oil bust has mauled the finances of oil producing countries, and their sovereign wealth funds, such as those of Norway and Saudi Arabia, have been selling assets and withdrawing billions from hedge funds around the world in order to prop up their public finances and battered economies.

And now it has trickled down to the numbers – the worst numbers for hedge funds since 2009.

Capital outflows in the first quarter reached $15.1 billion, the largest quarterly outflows since Q2 2009, according to Hedge Fund Research, “as volatile markets and early quarter performance resulted in falling investor risk tolerance and led to redemptions from underperforming strategies.”

That made two quarters in a row of outflows, the first such pair since 2009.

While some funds picked up assets, event-driven funds and macro-strategy funds got hit the hardest; their capital declined by $8.3 billion and $7.3 billion respectively.

It didn’t help that hedge funds in the aggregate also lost money in the quarter: -0.7% according to the HFRI Fund Weighted Composite Index. The loss isn’t huge. But you pay the ultimate “smart money” hefty fees so that they earn a high return for you. And a loss like this doesn’t fit into the scenario.

Interestingly, while they lost money in the first half when stocks were heading south in a hurry and when the bottom fell out of junk bonds, they didn’t lose as much as the overall stock market index. At the time, the industry bragged about its ability to ride out market turmoil and volatility.

But then, in the second half of the quarter, when the S&P 500 shot up 15% and when junk bonds soared, they missed part of the rally. And so they didn’t quite make back what they’d lost in the first half. Even lowly index funds beat hedge funds in the quarter – as they have been year after year since the financial crisis!

Between capital outflows and capital evaporation, assets under management declined to $2.86 trillion. HFR’s report put it this way: “The volatile performance environment continues to be dominated by intense dislocations, sharp reversals, and rapidly shifting correlations across assets….”

Those words are not particularly soothing to pension funds. They too see the hedge-fund drama-queens showing up in the media. And they compare the results to those of index funds and their own portfolios. And they’re thinking: if index funds can beat hedge funds, and if we can do it too, why pay the fees?

So what does “another gored bear” – who’s famously stuck to his own business, real estate, and gold while lambasting stocks for years even as they have soared – do to try to “tilt the odds” in his favor in the “shabby world of money?” Here are his doubts and his thought process for a radical shift. Read…. The Man I’m Betting $5 Million On

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  1. Steve H.

    – if index funds can beat hedge funds, and if we can do it too, why pay the fees?

    If the index fund is no-load, you can tell your net gain without getting sandbagged when you cash out. I maintain that has value in itself.

    1. Mark Waterman

      Odds are good that index funds will kick that snot out of hedge funds even if you don’t take fees into account.

      Just look at how Warren Buffet’s $1 million bet against hedge funds is doing: Over 8 years, his index portfolio is up 65%, versus 22% for the hedge funds picked by Protege Partners.

  2. cnchal

    “If they were truly fiduciaries and cared about our members, they would never charge large fees for failing to deliver on their promises,” she told the Financial Times. “Let them sell their summer homes and jets, and return those fees to their investors.”

    A few weeks ago we learned about the latest finance scam coming out of Tel Aviv, binary options. One of the people involved justified his involvement by saying he didn’t want to live like a rodent.

    In a fair system, half the people involved in finance should be living like rodents, in a prison cell.

  3. flora

    Thanks for this post. Good to see pension boards and others finally waking up.

    “Calpers interim CIO Ted Eliopoulos said at the time that, “at the end of the day, when judged against their complexity, cost and the lack of ability to scale at Calpers’ size,” the hedge fund program “doesn’t merit a continued role.”

    NC’s factual reporting is slowly but surely having a good effect.

  4. Chauncey Gardiner

    Bigger question: Funds have been flowing out of stocks since February 11, 2016, yet the price of stocks has been rising sharply over this same period, with the S&P 500 index up over 15% for the 10 week period through April 20. So who has been buying stocks, why, under whose mandate, and why is this being hidden from the People?

    With imposed austerity, deteriorating infrastructure, funds shortages in our public education system, and so many other public needs going begging, using public monies to push up the prices of stocks is not only outrageous, but another implicit admission of failure of the neoliberals’ “free markets” capitalism. These are anything but free markets.


    1. cnchal

      . . . So who has been buying stocks, why, under whose mandate, and why is this being hidden from the People?

      The S&P 500 companies are buying their own stock with borrowed money so that corporate executives can openly loot even more. Not hidden at all. It used to be illegal, but that got changed decades ago after the bought politicians performed their duty to the plutocrats at the time.

      1. Chauncey Gardiner

        Thanks, cnchal. I thought about that factor too, and think not. Assuming the S&P 500 index is reflective of the broader market, the Total Market Capitalization of U.S. stocks was $21.6 trillion at April 20. Assuming the S&P 500 index is reflective of the market, 15% of that amount is a total gain of a little under $3.2 trillion in only 10 weeks.

        Total corporate stock buybacks AND dividend payouts were $934 billion in 2014 according to a CNN article based on a report by S&P Capital IQ, and were estimated to be about $1 trillion by CNN for the entire year 2015.


        1. Jim A.

          Well I think that stock buybacks are being improperly priced in by the market. At some level, they should be a nullity since the liquidation value of the company is decreased since there is less money on hand. But with P/E ratios so high, the stock value is based on the anticipation of higher stock prices. And people still act like higher equity prices are base on anticipated future growth, instead of looting the company until you drive it into bankruptcy, when liquidation value suddenly matters again.

        2. MLS

          The dollar values don’t need to match for the market to go up. A simple example:

          There is one company in the market and it’s worth $100 and has 100 shares ($1 a share). You are the only investor in the market purchase a share for $1.05. The company is now worth $105 and has gone up $5 even though you only put $1.05 into the market.

          cnchal is probably on the right track that corporate buybacks are driving a lot of the market appreciation, and individual investors could be cashing in mutual fund holdings to buy individual stocks. I am thinking specifically about individuals moving away from funds to go buy high dividend stocks that are perceived to be “safer”. The flows out of core funds into value funds (which tend to pay higher dividends) and the performance of consumer staples and utility stocks (until recently) like General Mills, P&G, Wisconsin Energy, etc. suggests this may have been the case.

    2. Jim Haygood

      Nothing is being hidden. A know-nothing journo wrote “outflows from stocks,” when in fact the cited data is on flows from stock funds, not “stocks” as an asset class.

      When stock funds shrink their holdings, they sell their shares to other investors.

      It reminds me of a Bloomberg journalist who used to speak of “the foreign exchange” as if were a building in downtown Manhattan.

      A midwestern tourist asked directions to the Foreign Exchange and was told, “corner of toidy-toid and toid.”

  5. SomeCallMeTim

    At this point 2 and 20 sounds a little like spending the equivalent of 2 months salary on a wedding ring – history and practice vs. analysis.

  6. Bhaskar

    Aren’t you drawing a lot of conclusions from an outflow of $15 B from a base of $2860 B ($2.8 T)?

    1. Yves Smith Post author

      Investors are desperate for returns and have been piling into risker investment strategies, Money is pouring into private equity and again into junk bonds. Investors are also keen to find a bottom in oil to buy. The exodus from hedge funds is a big contrast to prevailing trends.

      Public pension funds are indeed starting to repudiate hedge funds as a strategy, Moreover, I am getting reports from hedge fund managers who think the game is over.

  7. Greg

    In his final paragraph, Richter is shilling for one of Bill Bonner’s advertising hustles. Richter has a right to earn a living, but for me I’m no longer paying attention to anything he writes because his viewpoint apparently is up for sale.

    1. Yves Smith Post author

      That is an ad hominem attack.It’s an invalid form of argument and against site rules.

      And your attack is also off base. I know Wolf. While he does monetize his site, he doesn’t seek to max out what he makes from it, nor is it a major source of income for him. Bonner writes occasionally on Richter’s site and he may regard that as a courtesy. The final para of Richter’s posts always refer to other posts.

  8. Marc Andelman

    How could anyone make money if they invest in someone who wastes their time investing in North Korea, or, get this, suing the South Pacific of Nauru . See this NYT article http://www.nytimes.com/2016/01/14/business/dealbook/north-korea-is-newest-frontier-for-a-daredevil-investor.html?_r=0

    Nauru was once the wealthiest island in the south pacific. They are now the poorest, having sold their actual island off as phosphate rock. They earn a living from hosting a high security prison for Australia, and, a high level radiation dump. This hedge fund also funded a number of other anti-social things, like fronting the money used to sue an inventor of a water purification technology. I seem to recall they had 1.5BB once, now down to less than half that. The question is, who would give hedge fund clowns money to invest? The answer surely is people who have money and have made promises they cannot keep, like major university endowments and pension plans. That is scary.

  9. michael


    Wolf Richter always identifies guest posts very clearly. He is selling nothing which in my feeble mind makes him one of the few honest individuals on the web. He does not even ask for support of his site.

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