Hedge funds finally regained a shred of dignity in September: after a long stretch of frequently underperforming the broad stock market, the investment funds – which charge their clients hefty management fees – were able to do a bit better than the Standard & Poor 500 Index.
A standard yardstick of the industry’s performance known as the Hedge Fund Weighted Composite Index last month showed a narrow decline of 0.4 percent, Chicago-based fund tracker Hedge Fund Research reported this week. That’s not great, but it was a better result than the 1.5 percent drop the S&P 500 showed in September.
Once the high fliers of the investment world, hedge funds use sophisticated mathematical models and high-speed machines to routinely generate high returns for clients. In the 1990s, hedge funds generated eye-catching results, averaging 6 to 15 percentage points more than major benchmark indices, according to a 1999 study.
As their success grew more prominent, large investors like pension plans and university endowment funds happily placed large sums with hedge funds.
To make more money, to reap those higher returns, clients pay hedge funds a lot of money. The industry generally charges a 2 percent annual management fee and an additional 20 percent of profits earned.
In recent years, however, hedge funds have lost some of their charm, as the industry’s investment results have grown less impressive.
In fact, hedge fund industry underperformed the S&P 500 nine out of the past twelve months.
That matters, because hedge fund investors could have easily invested in an index fund that matches the S&P 500 and made more money without paying hefty management fees.
Some have already made plans to leave hedge fund investments. The California Public Employees’ Retirement System, the largest retirement plan in the U.S., recently announced that it would pull back its $6 billion worth of investment.
“Hedge funds are certainly a viable strategy for some, but when judged against their complexity, cost, and the lack of ability to scale at CalPERS’ size,” a pension-plan official said at the time, the hedge fund investment program “is no longer warranted.”
Still, many retain their strong faith in hedge funds.
Despite the modest drop, “the September performance was in line with normal performance volatility and in no way indicative of a decline in the hedge fund industry,” said HFR president Kenneth Heinz during a conference call on Wednesday.
Most hedge funds invest not just in equities but in a spectrum of assets, from real estate to derivatives, and the HFR index outperformed the S&P 500 because of such non-equity holdings.
For that reason, investors see hedge funds as a downside protection in case the market takes a downward turn.
Components in hedge fund strategies and the stock market are not in a straight-line relationship, said finance professor Vikas Agarwal. “Hedge funds are not just exposed to equity market, so stock market performance is not quite the right benchmark to evaluate hedge funds,” he added.
When the market crashed in 2008, hedge funds were relatively doing well with their diverse portfolios, but their 1990s heyday hasn’t returned.
Investors still interested in hedge funds are not necessarily looking for returns in stocks, the finance professor said. Hedge funds can help investors get exposure in investment areas like options and arbitrage that are not easy for an individual or organization to access.