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Hedge funds look like they're down for the count, having been beaten-up by self-inflicted underperformance in the face of over-the-top fees, high-profile slip-ups, and investors stepping over them on their way to low-cost, passive investing strategies.
But don't count Hedgies out just yet…
One reason hedge funds have been underperforming benchmarks has become abundantly clear and can be overcome (as you'll see). They're also knocking down fees to hold onto investors and attract new limited partners.
Not only that, the multitrillion-dollar trend towards passive investing could blow up spectacularly.
Today, I'm going tell you what's going on with hedge fund underperformance, those exorbitant fees, and why the trend toward indexing could be hell for the market and a godsend for hedge funds.
But first, let's all get on the same page…
What Is a Hedge Fund, Anyway?
The first hedge fund, created in 1949 by Alfred Winslow Jones, was designed to hedge the ups and downs of the stock market. Jones figured he'd divide the money he was going to manage into two equal buckets. Half of his positions would be "long" positions (stocks he would buy), and the other half of his positions would be "short" positions (stocks he'd sell short, a bet prices would go down).
If the market went up, his long positions would go up and make money, and if the market went down, his short positions would go down and make money. Which makes sense – except the two opposing buckets would just cancel each other out.
But Jones had a plan. Because he was such a good stock picker, he explained to investors, when the market went up his long positions would go up more than the market. And because he could pick good shorts, they wouldn't go up as much as the market, so he wouldn't lose much on being short. And when the market went down, because he was a good stock picker his long positions wouldn't go down as much as the market, and his short positions would go down more than the market dropped.
Jones sold his investors on the proposition that they were hedged against the market's fluctuations and because he was able to generate "alpha" (a return better than the market) because of his stock-picking abilities, he would charge them a management fee and take a good percentage of the gains as a performance fee.
That's how the term "hedge fund" came about, while the prospect of generating "alpha" is how managers justify performance fees.
The entity structure Jones used was a limited partnership. Jones was the "general partner" of the limited partnership, managing its portfolio and business, and investors came in with their money as "limited partners." A limited partner has "limited liability" in a limited partnership. Because they aren't involved in running the business, they aren't responsible for losses beyond the investment money they initially put at risk.
Today, "hedge fund" is a generic name for a limited partnership, a limited liability company, or some other entity structure where investors fork over money to a manager to invest however he or she sees fit.
There are all kinds of "strategies" managers employ to make money, including: fundamental; technical; long/short; long bias, short bias; market neutral; relative value; value-oriented; multi-strategy, global-macro; special situations; event-driven; merger arbitrage; systemic; credit strategies; high-yield credit; commodity-based; real estate-based; and on and on and on.
Today, a manager can invest in almost anything as long as they disclose to investors what they're doing. However, some investor disclosure documents tell potential investors they're not going to tell them what they're going to do, or how they're going to do whatever they do.
Good luck suing the manager of a fund for losing money if you sign off on giving them carte blanche.
In spite of the designation hedge fund, most hedge funds today don't hedge against market moves.
That's one reason funds too often underperform in down markets. But there's another much bigger reason why so many funds have been underperforming for so long.
About the Author
Shah Gilani is the Event Trading Specialist for Money Map Press. In Zenith Trading Circle Shah reveals the worst companies in the markets - right from his coveted Bankruptcy Almanac - and how readers can trade them over and over again for huge gains.Shah is also the proud founding editor of The Money Zone, where after eight years of development and 11 years of backtesting he has found the edge over stocks, giving his members the opportunity to rake in potential double, triple, or even quadruple-digit profits weekly with just a few quick steps. He also writes our most talked-about publication, Wall Street Insights & Indictments, where he reveals how Wall Street's high-stakes game is really played.