Hedge Funds Succumbing to Mutual Funds’ Mediocrity: David Pauly

Date: Tuesday, October 19, 2010
Author: David Pauly, Bloomberg

Those free-wheeling investment vehicles with assets of $1.6 trillion nosedived during the credit crash and recession -- and won’t regain their glory.

Hedge funds won’t disappear. There always will be traders from Goldman Sachs Group Inc. who will start new ones in search of even-higher pay and retired and fired Wall Street executives who will join them.

Still, hedge funds are destined to become like mutual funds: They will have trouble beating the markets.

Hedge funds made their mark chalking up out-sized annual profits like 30 percent or more for their investors. The better the returns, the more funds were started. There are now more than 6,900 such funds, according to Hedge Fund Research Inc. in Chicago.

With so many of them digging in the markets, the opportunity for a unique investment payoff becomes less and less.

Is there any piece of knowledge these days that isn’t instantly broadcast? If one fund’s computer program pops up with a new idea, other funds quickly get into the same game, reducing the advantage.

This is the history of mutual funds repeated. There are more than 7,600 mutual funds in the U.S., according to Investment Company Institute, a Washington-based trade group, and many investors have given up hope that they can consistently beat the crowd. They have switched to index funds, which track a set list of investments.

Hedge Fund Fees

Of the households that invested in mutual funds in 2009, 27 percent owned at least one index fund, according to ICI.

Hedge funds will also have a cost problem if market returns in the coming years tend to be modest, as many pundits predict.

When times are tough, people look for low-expense investments. Hedge funds are anything but. Besides their ordinary expenses, they take 20 percent of any profit.

Investors may have ignored that when a fund gained 50 percent in a year buying gold or trading credit-default swaps. But after months of losses and poor returns, they are balking. The average hedge fund returned 4.59 percent this year through September, according to Hedge Fund Research.

Several hedge fund managers have begun closing shop, most notably Stanley Druckenmiller, 57, who says he’s tired of the stress and frustrated because his recent returns haven’t matched those of the past.

Free to Roam

Hedge funds may have an advantage over mutual funds because they can invest almost any way they choose. They can sell short, betting that stocks will drop. They can buy distressed debt and real estate. They can bet on movements in currencies and commodities. The problem is they run with the herd.

Hedge funds and other big speculators, for instance, increased their bets on crude oil in the week ended Oct. 5 to the most since last spring, according to the Commodity Futures Trading Commission.

Why? Because they think the Federal Reserve will try to stimulate the U.S. economy even more. Is there any investor in the world who hasn’t read or heard that? Crude has rallied since mid-September. The funds hardly seemed to be getting in at the bottom.

The attraction of hedge funds will die hard. Many investors -- pension funds, for example -- may think hedge funds will beat the markets even if their returns are much lower than those of the past.

They may be encouraged by a recent statistic on mutual funds. So-called managed stock funds actually beat the Standard & Poor’s 500 Index in the 10 years ended Oct. 12, returning an annual average of 2.3 percent, compared with a 0.59 percent gain for the index, according to Morningstar Inc., a Chicago-based research firm.

The years ahead may be tough for all investors. You can bet that the shrewdest of them are thinking of anything other than hedge funds.

(David Pauly is a Bloomberg News columnist. Opinions expressed are his own.)

To contact the writer of this column: David Pauly in Normandy Beach, New Jersey, at dpauly@bloomberg.net

To contact the editor responsible for this column: James Greiff at jgreiff@bloomberg.net