Have Hedge Fund Managers Lost Their “Hedge”?

November 23, 2011

The big story in the hedge fund world this year has been the poor performance of fund managers who seem to have lost their “hedge” in the face of one of the most volatile stock markets ever experienced. As a result, in what could be the next big story, investors have grown increasingly impatient and may be rethinking their allocations to hedge funds as evidenced by the outflows that occurred last month. Although most of the outflows will turn out to be inflows into other, more successful hedge funds, the message is clear: Investors want results for their management fees.

The emerging back story on this year’s hedge fund performance is the growing consternation among investors who have come to expect their funds to at least outperform the S & P 500, which, to them justifies the 2% management fee.

A recent analysis on hedge fund and S & P 500 correlation done by Morgan Stanley won’t do anything to ease investor anxiety. Using the HFRI Equity Hedge index, it shows that the correlation has grown from .04 in 1995 to nearly .09 in 2011, and the trajectory continues to point up. The alarming aspect of this is that the index is based on the performance of all types of equity-based funds which seek to distance their correlation with the market.

In the aggregate, the performance of these funds over the last 15 years bears a striking resemblance to the performance of the S&P 500 during that period as seen in the chart below.

Source: Morgan Stanley

Of course, the analysis is based on equity-based hedge funds. Macro funds have managed to maintain their correlation. And, there are still quite a few funds that are bucking the overall trend.  But, for equity investors, this raises the obvious issue of whether they could be just as well off investing in an index-tracking fund and pocket their fee expenses. It seems that that would have been the case, at least in the last five years.  Going forward, the challenge fund managers, and stock pickers in general, will have is in overcoming a market of tightening correlation.



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