WHY SOME HEDGE FUNDS FAIL
A hedge fund is one kind of an investment option as well as business structure that consolidates capital from multiple investors. They then invest that acquired pool of capital in securities and other instruments.
Most of the time, hedge funds are structured as limited liability companies (LLCs). Compared with mutual funds, the use of leverage in hedge funds is not limited by regulators. Compared with private equity funds, hedge funds invest in liquid assets.
Many investors have struck luck just by investing in hedge funds. However, this doesn’t always happen. These types of funds have been said to be underperforming. And the following are the possible reasons.
The Size of the Industry
The hedge fund industry has managed to increase its assets tremendously from 1997 (in which it had $100 billion worth of assets) to 2015 (in which it had higher than $250 trillion worth of capital). Before, there were only a few hundred fund managers. Nowadays, there are more than 10,000 of them.
The idea behind hedge funds is to create the alpha, or abnormal returns. As the industry grows, the more it hurts the goal of generating the alpha. What rules alpha is the idea that actively managed portfolios are the best when it comes to achieving these abnormal or excess returns.
Since there are current countless fund managers, the talent pool of the people who have the potential to achieve the alpha has been diluted.
Moreover, the generation of abnormal returns may be a very limited source. The alpha can be achieved by leveraging market inefficiencies. And these inefficiencies are not unlimited, so there might not be enough of them for the number of fund managers around.
The Size of the Fund
There are quite a number of studies that have shown an inverse relationship between the size of a successful fund and the manager’s ability to generate the alpha.
As hedge funds become successful, more money flows into the funds, which weakens their ability to outperform. This happens because the assets under management (AUM) swell, and this means that fund managers are more concerned with losing money. This pushes them to index the market instead of going after abnormal returns.
Meanwhile, some fund managers try to force the excess money into trades that are less than what they deem is profitable.
Unhedged Hedge Funds
Hedged funds nowadays have already become unhedged. In other words, a lot of hedge funds have become highly leveraged, limited-active trading instruments.
During the years of economic recession, the quality of hedge funds (being unhedged) has helped it avoid losing money. However, after 2008, this lack of hedging has led to funds losing enormous amounts of capital.
Since 2008, it has been reported that hedge funds have already lost all their prior profits from an industry perspective.
Behavioral Factors from Investors
When choosing a fund manager, the average institutional investors sport a number of biases.
In many cases, a lot of investors look at the past performance of the fund instead of looking at a fund manager’s way of picking investments. But processes can be a more reliable indicator of funds that will perform well in the foreseeable future.
Many investors pick funds that underperform in the longer run, causing more money to be wasted on poor-performing funds.
