An article in Barron’s points out a disconnect between assets and returns of hedge funds:

As of Sept. 30, the industry managed a record $2.51 trillion in assets, according to the analysts at Hedge Fund Research. That’s also a huge recovery from the depths of the financial crisis, when the funds’ $1.87 trillion in assets fell by $400 billion.

The HFRI Fund Weighted Composite Index, which covers a wide range of strategies, was up only 5.5% from Jan. 1 to Sept. 30, while the S&P 500 rose 19.79%. The poor showing was no better than during the 10 years ended on Sept. 30, when the index, compiled by Hedge Fund Research, was up only 5.92% on an annualized basis.

Annualized returns for other periods to September 30 compiled by Hedge Fund Research (HFR) are also unimpressive:

Index 1-Year 3-Year 5-Year
HFRI Fund Weighted Composite Index 7.05% 3.85% 5.01%
HFRI Equity Hedge [EH] (Total) Index 11.08% 4.61% 5.22%
HFRI Event-Driven (Total) Index 12.32% 6.22% 6.85%
HFRI Macro (Total) Index -2.92% -0.60% 1.83%
HFRI Relative Value [RV] (Total) Index 7.18% 6.13% 7.70%
HFRI Emerging Markets (Total) Index 6.66% 0.22% 4.28%
HFRI Fund of Funds Composite Index 6.58% 2.50% 1.95%
HFRI EH: Short Bias Index [lowest] -17.06% -13.02% -12.79%
HFRI RV: Fixed Income-Asset Backed Index [highest] 10.19% 10.60% 12.01%

Not surprisingly, in the environment of low interest rates and modest economic recovery, the short-biased funds had the worst and the fixed income funds had the best performance in the past five years.

Meanwhile, the compensation of hedge fund personnel increased more in line with assets under management rather than performance. Per a Barron’s blog post, the 2014 Glocap Hedge Fund Compensation Report states the following figures:

A new study contends an entry-level analyst at a middling large hedge fund is taking home $353,000 this year. The figure, which includes salary and bonus, rises to $2.2 million for the average portfolio manager of a large fund. Overall, average compensation in the industry gained between 5% and 10% for the year.

This surely contributed to the huge increase in the number of hedge funds: from 2,392 in 1996 to 8,201 at present (567 more than before the financial crisis).

The influx of money into hedge funds is caused by institutional investors that, according to the 2013 Glocap Report, account for 77% of capital compared to only 12% contributed by high-net-worth individuals and family offices. The main reason is that after the financial crisis institutions want to minimize losses during market downturns, while sacrificing the upside during market rebounds (in 2008, the HFRI composite index fell 19.03%, while the S&P 500® lost 37.0%).

Also, hedge fund returns are supposed to exhibit low correlation with those of the market, which leads to improvement of return-to-risk characteristics of the investment portfolio. However, as the following chart from the HFR presentation to the US Dept. of Labor shows, historical correlation of the HFRI composite index to the S&P 500® has been quite high:

HFRI Correlation to S&P 500® (12-Month Rolling Window)

Furthermore, the correlation of the equity hedge fund index to the S&P 500® has been on the rise for a long time, which makes it very difficult for such funds to beat that benchmark:

Correlation of HFRI Equity Hedge Index with S&P 500&reg (Rolling 60 Months) Jan 1990 - Oct 2011

In sum, while some, especially smaller, hedge funds have attractive characteristics, performance of the overall industry leaves a lot to be desired.

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