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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 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.