In fact, the industry as a whole hasn't seen anything like this since 2009 - maybe ever.
Ironically, the pain hedge funds are facing, based on the pain their trades have inflicted, holds the answer not only to their survival, but to an almost sure miraculous revival.
Understanding what's gone wrong at hedge funds, how crowding into the same trades, staying too long in trades when cash registers should have been ringing, and how underperformance led to fee wars and investors fleeing for passive index funds, produces the roadmap funds have to follow to make a comeback.
And it shows average Joe investors how they can play the same profitable future.
Let me show you what I mean...
Exiting Sinking Ships
It's not just 2016 that's been tough for hedge funds. Investors in hedge funds and hedge fund managers would like to forget every year since 2008. But they can't.
According to Bloomberg, the S&P 500 Index, sometimes referred to as "the market" which investors can invest in by buying an indexed mutual fund or a low-cost ETF, outperformed the weighted-composite index of hedge funds every year since 2008.
From 2009 through the first quarter of 2016, hedge funds underperformed the S&P 500 by a whopping 51 percentage points.
In 2015, when the HRFI Fund Weighted Composite Index (an equal-weighted index of hedge funds) was down 1.1%, the S&P 500, with dividends included, had a 1.2% gain.
Even in the full first half of 2016, with funds averaging a 1.6% gain, the S&P 500 posted a 3.8% gain.
It's bad enough investors are underperforming basic indexes, but adding insult to injury, they're also paying exorbitant fees to managers to be in the losing game.
Typically, hedge funds charge a 2% management fee. That annual fee, based on assets under management, which is usually collected on a quarterly basis, is paid to the manager regardless of gains or losses.
On top of the management fee, hedge funds take a healthy piece of the gains they generate.
Historically, the performance fee charged is 20% of profits.
The so-called "2 & 20" fee structure has been the standard for hedge funds for decades, though some very successful funds have charged a higher management and a higher performance fee. I've seen funds charge a 3% management fee and up to a 50% performance fee!
Investors have been aggressively negotiating down both management fees and performance fees in the face of pure ugliness. While 1% & 15% fee structures are becoming more prevalent, managers sometimes negotiate fees with different investors, providing they're allowed to do that according to their fund disclosure documents.
But no matter how low a fund may be willing to drop its fees, investors have had enough.
The first giant institution to split from the hedge fund universe was the California Public Employees Retirement System, CalPERS, which in January 2104 started throwing in the towel. Over the past 20 months, CalPERS exited 24 hedge funds and six fund of funds, withdrawing about $4 billion from the industry.
The giant New York State Common Retirement Fund, one half of a two-fund complex that has $181 billion in assets, lost $3.8 billion as a result of hedge fund underperformance and exorbitant fees, according to a just-released report from the New York Department of Financial Services. The system stopped investing in hedge funds last year and has withdrawn $1.5 billion this year.
So far in 2016, the Kentucky Retirement System has taken back $1.5 billion from hedge funds. The State of Massachusetts is cutting back all its alternative investments. College and university endowments are cutting back their hedge fund exposure on an almost daily basis.
According to the Credit Suisse Mid-Year Survey of Hedge Fund Investor Sentiment, a study of 200 hedge fund allocators directing $700 billion of investment capital, 84% of investors in hedge funds pulled money out in the first half of 2016. And 61% said they will probably make withdrawals later in the year.
Why Hedge Funds Aren't Making Money
There are two basic problems hedge funds are having trying to make money. Today I'll explain one and next week I'll lay out the other, less obvious, busted strategy that's killing performance.
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The number one problem facing funds is they're crowding into too many of the same stocks and creating massive correlation.
There are only so many stocks and so many trades to go around in the $3 trillion, 10,000 fund universe of hedge funds. As more funds ply the same trades and as big funds have gotten bigger, the need for scale increases.
That means more and more fund managers are crowding into positions that consume larger pieces of companies outstanding, floating shares.
That's fine on the way into a trade if you're early and other managers plow into those stocks creating momentum, which attracts momentum-driven funds, which attracts more investment capital. But it's exiting those positions, sometimes like rushing for the exit doors when someone yells fire, that crushes performance across a wide swath of funds.
According to Andrew Lo, acclaimed professor of finance at the MIT Sloan School of Management, "The whole hedge fund industry is a series of crowded trades."
Back in a 2011 study, Lo found that from 2006-2010 there was a roughly 79% chance "any randomly selected pair of hedge funds will move up and down in tandem in a given month." That was up from 67% in the 2001-2005 period. It's worse today, says Lo.
In a speech on Sept. 20, 2016, at the RiskHedge USA conference in New York, Mike Jemiolo, chief risk officer at Point72 Asset Management said, "The biggest challenge right now is crowding, the problem is that for many, many years crowding worked - if you loaded on that factor, you made money. But starting in mid-2015, long crowding stopped working pretty steadily and fairly catastrophically in January and February, and in late 2015 - December or so - short crowding stopped working too."
Basically, investing in crowded stocks exposes investors to shocks and liquidity demands that are not always explicitly captured in risk models.
A perfect example of overcrowding in a trade and the pain a massive exit causes is Valeant Pharmaceuticals International Inc. (NYSE: VRX). After touting Valeant at several investor conferences and publicly, hedge fund manager Bill Ackman of Pershing Square Holdings found he had a lot of company in VRX.
According to Novus research on June 30, 2015, VRX was the most crowded position on a list of 10,000 funds from Novus' Hedge Fund Universe. Novus in its report pointed out that in spite of the overcrowding, not a single healthcare-focused fund was heavily invested in VRX.
In April 2015, when VRX got above $260 and was held by more than 106 hedge funds, accounting for 38% of its floating stock, as the stock began to tumble, daily volume went from 1.8 million shares to 18 million on a 90-day rolling average.
Hedge funds were slaughtered all the way down to $22.27, where VRX stock trades today. None more so than Ackman's Pershing Square.
Pershing Square was down 20.5% in 2015 and was down 21.1% in the first half of 2016. Assets under management at Pershing shrunk from $20 billion to $12 billion over the same period. Billions of dollars continue to be withdrawn from Ackman's funds.
That's the problem with overcrowding.
Soon, I'll explain the other "strategy" hedge funds are following that's killing them, and I'll tell you where the exiting money is going and why.
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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.