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Investors are returning to hedge funds. That may be unwise


Superheroes are useless when times are good. If Gotham were a safe and pleasant place, Batman would probably spend his days relaxing in a boarding house. Superman only steps into a phone booth to reveal his blue and red lycra when the bad guys are holding someone up at gunpoint.

For the better part of a decade, the financial markets were largely calm. The s&p 500 index, the leading measure of American stocks, rose steadily higher from 2010 to 2020. As expected interest rates trended lower and lower, bond prices largely rose as well. Investors worried about losing in the bull market for life, not about whatever risks were around the corner. The circumstances were therefore dire for institutions that aim to be useful during turbulent times, such as hedge funds. They often look for returns that are uncorrelated with the broader stock market, to soften the blow an investor may experience when markets fall. In volatile markets, a superhero manager – known as a “hedge-man” is supposed to step in and protect investors from losses.

Hedge fund sales were difficult for much of the 2010s. Investors stuck with them for the first half of the decade. But as stock market returns continued to lag, net asset growth (a measure of whether investors are pulling money out of funds or putting money into them, measuring the impact of investment returns) turned negative. In the second half of the decade, hedge funds blew money and hedge men hung up their heads. In almost every year since 2015, more funds have closed than opened.

After ten years in the spotlight, things are now looking up for the hedge man. Money, on the net, has flowed into funds every quarter this year. If business continues at the same pace, 2023 will be the best year for hedge funds since 2015. The total amount invested in funds is now more than $4trn, up from $3.3trn at the end of 2019. And this year more funds are open than closed.

What is to be gained from the return of the hedge man? Investors may be heavily influenced by recent events. Last year hedge funds hit the market. The Barclays Hedge Fund Index, which measures industry-wide returns, net of fees, lost just 8%, while the s&p 500 lost a more uncomfortable 18%. But hedge funds have completely underperformed US equity indexes in every other year since 2009, returning an average of just 5% a year over the period, versus a 13% gain for the broader market. In 2008 Warren Buffett, a famous investor, bet a hedge fund manager $1m that money invested in an index fund would outperform a hedge fund of his choice over the next ten years. Mr. Buffett won comfortably.

The renewed enthusiasm for hedge funds may also signal a deeper unease: perhaps people have become convinced that the easy returns of the 2010s are well and truly in the past. Most investment portfolios have been implemented by the end of easy monetary policy. As Freddie Parker, who allocates money to hedge funds for clients of Goldman Sachs, a bank, hedge fund performance tends to look healthier during periods of rising rates, as these tend to be accompanied by a “more challenging environment”. Hedge fund performance is also stronger during periods of high or volatile interest rates, such as the 1980s and mid-2000s.

Of course, high interest rates don’t necessarily mean the good old days are back for the hedge man. Today’s markets are high tech and lightning fast. Information spreads around the world instantly and is instantly incorporated into prices through high-frequency trading algorithms. In contrast, in the 1980s it was still possible to gain an advantage over your competitors by reading the newspaper on the way into the office. Although many hedge funds closed their doors in the 2010s, there are still many more than in the 1980s or 1990s. The competition—for traders and trades—is much fiercer than it used to be.

It is understandable that, when faced with a world of high and volatile interest rates, investors look for those who can save them from risk. But consider how Mr. Buffett’s bet performed. In 2008, a turbulent year for stocks, its index was handily beaten by hedge funds. It was the outstanding performance over the next nine years that won him the bet. “It’s always darkest before the dawn,” says Harvey Dent, an opponent of Batman, in one of the films, “and, I promise you, the dawn is coming.” When it comes down to it, investors may wish they had stuck with their index funds.

Read more from Buttonwood, our financial markets columnist: Why it’s time to retire Dr. Copper (October 19) Investors should be careful with bond yield analysis (October 12) Why investors can not escape China disclosure (October 5)

Also: How the Buttonwood column got his name

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