They call Wall Street's big hedge fund managers the "Masters of the Universe," the ultra-wealthy, extremely powerful, undisputed lords of finance who seem to exist in a gilt world that consists solely of London W1, the Upper East Side of Manhattan, and Greenwich, Connecticut.
But… all is not well in the ivory tower. The "Masters of the Universe" just might be an endangered species.
The financial media has been pumping out stories about struggling funds, disgraced managers, and fleeing investors, all quoting high-profile critics of hedge funds. Even the old Occupy Wall Street gang, jarred by the media from their long nap, is back with a new movement: "Hedge Clippers."
That's not just noise. There's a good reason for the growing widespread discontent with the antics of Wall Street's legendary "hedgies." Investor patience is running out.
But luckily for us, the hedge funds' fall from heaven is likely to be a godsend to independent investors.
But first, a full disclosure: I used to be a hedge fund manager, so I've got an insider's view on what's happening here, and it's going to be big.
What a Hedge Fund Is (and What It Isn't)
For as much mystique as hedge funds and their managers command, plenty of folks don't quite have the whole picture.
One of the biggest misconceptions is that hedge funds, well, hedge. The truth is, hardly any funds hedge their positions anymore… as evidenced by the fact that the Barclay Hedge Fund Index shows these funds have returned a measly 0.22% on average in 2016.
Hedge fund has simply become the generic name for a fund, usually structured as a limited partnership, where the general partner manages money put in by limited partners, and pooled capital is invested based on the general partner's investment strategy.
A hedge fund can be an investment vehicle that invests in stocks, bonds, commodities, all three, or in mortgages, or derivatives, or foreign currencies, or bets on foreign stocks, or real estate, or art, or just about anything that investors believe a manager can make money investing in. And some hedge funds actually try and hedge.
Then there are the fees… the infamous "2 & 20."
Because fund managers boast they can make huge sums of money with their strategies, and investors expect them to, they charge limited partners a management fee and a performance fee.
A management fee, typically 2%, is a flat fee managers charge just to handle investors' money. Regardless of whether the manager makes or loses money, investors pay 2% of the money they have in the fund.
While a 2% annual management fee is good money, it's chickenfeed to hedge fund managers.
Hedge fund managers are in business to make performance fees. A performance fee, typically 20%, is what the manager takes off the top of profits he makes to pay himself for his good work.
That's why managers or funds that charge these fees are sometimes called "2 & 20 managers," or "2 & 20 funds."
It's the "2 & 20" cost to be in hedge funds that everyone's bashing these days.
Investors don't mind the exorbitant fees if managers deliver rich, market-beating returns.
It's when they have to pay for subpar returns, or have to pay management fees, even if the manager loses money, that's making investors, the media, hedge fund haters, and some investment managers cry foul these days.
The reason the heat's on hedge funds is because their performance has been so cold for so long. Have a look at some of these numbers… It's not pretty.
Why Would Anyone Pay Money for This?
The Hedge Fund Intelligence Americas Global Equity Index, an industry benchmark, fell 3.2% in the first quarter of 2016 – that's before fees. Meanwhile, after a 10% drop early in the quarter, stocks, measured by the S&P 500 index, bounced back ending the quarter with a .6% gain.
The Americas Global Index gained just 0.56% percent in 2015, while the S&P 500, including dividend reinvestment, returned 1.38%.
That's right. An investor could simply go on autopilot and track indexes (and not pay the
2 & 20) and leave the "Masters of the Universe" in the dust.
This is not a recent development; since 2008, hedge funds as an investment class have been trounced by the S&P 500 Index.
From 2009 to 2015, the S&P 500's total annual return including dividends was 107.09%. Over the same period the Barclay Hedge Fund Index, a measure of the average return of all hedge funds (except Fund of Funds) in the Barclay database of more than 6,000 funds, returned just 29.67%.
So it's high fees for poor performance that's causing the multibillion-dollar exodus out of hedge funds.
While the total assets under management by all hedge funds stands at $2.86 trillion, $1 trillion more than in 2007, funds are seeing huge outflows at an unprecedented pace.
Last year, fully 979 hedge funds closed their doors due to poor performance and investor redemptions.
From Q4 2015 through the end of Q1 2016, hedge funds suffered $16.6 billion in outflows. The last time the industry saw anything like that was in 2009.
The tough environment that's hammering performance is expected to get even tougher this year.
They're All in It Together… and That's a Problem
One fund that's garnered tremendous media attention, Pershing Square Capital Management run by Bill Ackman, is the poster child for underwhelming performance and, consequently, most everything that's ailing hedge funds these days.
Pershing Square has lost over $5.5 billion in the last 15 months on one very, very bad bet: Valeant Pharmaceuticals International Inc. (NYSE: VRX). Valeant's stock price is down more than 89% from a 52-week high of $263.81 to less than $28 today.
Pershing Square isn't the only fund suffering with Valeant. A lot of other fund managers followed Ackman into Valeant.
So Ackman was most definitely not alone in his big, bad bet.
As funds have gotten bigger, they need to take on bigger positions. You see, allocating small sums to lots of positions doesn't work for multibillion-dollar hedge funds because even huge gains on small positions won't move the performance needle in any meaningful way.
Big funds' size dictates the size of positions they take. And big positions, when they go against you, are a nightmare.
But that's only one side of the problem facing hedge funds. The other side looks remarkably similar. That's because an ever-increasing number of hedge fund managers end up in the same trades, holding the same positions.
Whether fund managers piggyback big-name investors like Bill Ackman, who openly tout their big plays hoping other managers will follow them into stocks (and in the process bid up share prices up), or whether lots of funds end up with the same positions because big investing themes are well-known doesn't really matter.
What matters is that funds chasing the same themes and positions end up performing a lot alike.
If that performance is bad, and funds take bigger risks to try and outperform benchmarks, they are going to lose investors' confidence in their abilities… along with hundreds of billions of dollars.
Legendary (and lately infamous) hedge fund master-trader Steven A. Cohen recently told Reuters, "When this business started, guys took pride in the returns that they generated. Guys would make 20%, 25%, 30%." Cohen, who for years generated those kinds of returns, went on to say, "Now it's about trying to figure the intersection between assets under management and what investors would be willing to accept."
And when someone's trying to find an intersection… they're lost.
Buffett's Big, Bold Bet
Famed investor, the Oracle of Omaha, Warren Buffett, reminded the rapt audience at his Berkshire Hathaway annual meeting recently about the 2008 (pre-Crash) bet he made with hedge fund Protégé Partners.
Now, according to Buffett's terms, Protégé could pick any five fund-of-funds and track their cumulative returns over the next decade, while Buffett wagered they'd get beaten by the Vanguard S&P 500 Index Fund Investor Class (MUTF: VFINX).
Buffett showed the gathering a chart comparing the cumulative returns of the two sides of the bet since 2008…
As of the end of 2015, the S&P 500 Index fund had a cumulative return of 65.7%, including the big losses of 2008…
…which handily beat the Protégé team's 21.9% return.
Buffett also pointed out the S&P 500 has outperformed in six of the eight individual years of the bet.
On the other hand, Stanley Druckenmiller, the billionaire trader who used to run George Soros' giant hedge funds, told Sohn Investment Conference attendees last week to sell their equity holdings.
In a statement that may reflect the under-siege sentiment among fund managers, he told the audience of big-name investors and superstar hedge fund managers, "The conference wants a specific recommendation from me. I guess 'Get out of the stock market' isn't clear enough." His recommendation, as he put it, was, "gold remains our largest currency allocation."
There's no denying Druckenmiller will be safe with that play, of course, but he might as well allocate capital in canned peaches, Spam, and AA batteries for all the return he'll likely see.
He's right to be nervous. Hedge fund bashing, and, much more importantly, outflows, are only going to increase as market volatility increases this year, and we've already seen plenty of that.
In 2015, investors who followed the independent recommendations from myself and the other editors at Money Morning did more than 166 times better than Wall Street's "best and brightest."
And in 2016, more than ever, independent investors with vision, a sound thesis, and the flexibility to take smaller positions in unstoppable profit trends are going to crush the hedge funds.
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About the Author
Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.
The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.
Shah founded a second hedge fund in 1999, which he ran until 2003.
Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.
Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.
Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.