We have seem claims of “the death of hedge funds” on a few blog posts and comments from some well-known participants acknowledging performance and structural issues. However, don’t hang the black crepe for hedge funds yet.
Yes, it’s been a tough time for the industry. The average hedge fund performance has been disappointing during this bull market, compared to the S&P 500. The HFRI Fund Weighted Composite Index has generated an annualized gain of just 1.7% over the past five years. The S&P 500′s average annualized return for the same period was 11%. Investors are pulling more money out of hedge funds than they’re putting in — something that hasn’t happened since 2009, according to Hedge Fund Research, which found more hedge funds are closing shop than opening up. However, Preqin reported in April that hedge fund assets topped $3 trillion in the first quarter, with outflows representing less than 2% of the total.
The big issue for observers is defining a real hedge fund as opposed to a highly correlated leveraged fund, or funds that run large net long positions versus true hedging. More significantly, there continues to be pressure on fees. Many liquid alternative hedge funds have flat fees without a performance carry. Technology is allowing a replication of some hedge fund strategies with even lower fees.
Furthermore, institutions are pushing back on the traditional 2-and-20 fee structure with some success. Performance that beats similar low fee structures will be able to push for higher fee structures. However, those funds are few and far between.
Those in the hedge fund industry (and to some extent, the private equity industry) have Alfred Winslow Jones to thank for the 20% incentive fee structure (he didn’t believe in management fees, according to a 2004 profile of his firm in Barron’s). Founded in 1949, A.W. Jones & Co. is considered the first modern hedge fund. Using what today might be called a factor-based model, combining elements of leverage and shorting, and running a “neutral” portfolio with as many stocks short as long, Jones created a structure of receiving 20% of the profits. He borrowed this structure from the old-time merchant sea captains who took 20% of a successful trip’s profits. Somehow, the 20% performance fee became the norm, with the asset-based “management fee” coming into play later.