Here's Why Hedge Funds Are Poised for a Comeback - and Why It Matters to You

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?

hedge fundsThe 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.

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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.

It wasn't always that way...

Hedge Fund Performance Has Tanked Since the 90s

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Though they've been around for decades, hedge funds exploded in the 1990s.

There have always been outstanding hedge fund managers, including legends Julian Robertson, George Soros, Stanley Druckenmiller, Ray Dalio, and Steve Cohen, whose long-term track records are extraordinary, partly proven by the success of their investors and partly proven by the fact they are all multibillionaires who eat their own pudding.

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Based on the HRFI (Hedge Fund Research Index) Weighted Composite Index, an equal weighted index of hedge funds, which tracks funds back to 1990, the funds that make up the index collectively delivered 10% annually to investors from January 1990 to February 2016, with a standard deviation of 6.8% and a Sharpe ratio of 1.04.

At the same time, the S&P 500 Index had an annual 9% return with a standard deviation more than twice as high, at 14.6%, and a Sharpe Ratio less than half the HFRI Index, at 0.42.

Bloomberg, from which this data was gleaned, defines standard deviation as "the performance volatility of an investment, while the Sharpe Ratio is a gauge of risk-adjusted returns; a lower standard deviation indicates a less bumpy ride, and a higher Sharpe Ratio indicates that investors are more adequately compensated for the volatility they take on."

As good as that hedge fund performance sounds, however, objects in the mirror are further away than they appear.

The actual rolling trend of the index shows a significant decline in returns since tracking began.

The HRFI Index actually returned 18.3% annually from 1990 to 1999, but on a rolling basis returned just 3.4% annually over the past 10 years. According to Bloomberg, it doesn't matter what strategies are broken out - they all suffer diminishing returns.

By comparison, the HRFI Index fell behind the S&P 500 Index by 3% annually over the past 10 years and fell behind the Barclays Aggregate Bond Index by 1.3% annually over the same period.

As if that wasn't bad enough, the Sharpe Ratio of the HRFI Index fell to 0.38, which was one-third of the 1.13 Sharpe Ratio earned by the Barclays Aggregate Bond Index.

What's going on?

In a word (or two), competition and overcrowding.

Too Many Funds, Not Enough Capital

Back in 1990, 610 hedge funds managed $38.9 billion of investor money. Today, there are more than 10,000 hedge funds globally, managing just shy of $3 trillion.

A lot of fund managers, competing rabidly against each other, are crowding into a lot of the same trades, no matter what the portfolio management strategy is.

Not only are managers clipping each other on the way into trades, bidding up prices of assets they're all chasing, they collectively get killed when they all head for the exit doors as soon as news leaks out (which they are all privy to) that some big money somewhere is exiting positions.

Soon I'll give you some devastating examples of how fund managers followed other managers into and then out of trades, why, and what happened. Some of these stories made the front-page news, and investors are still reeling from the devastation.

Not only will I cite specific examples and name names, I'll tell you who's doing what now and how that's about to wreak havoc across the entire market.

Then next week, I'll show you where the smart money's headed, and how you can follow it.

So stay tuned.

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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.

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