Hedge Fund Performance And Pruning

There is an interesting article over at the Economist regarding hedge fund returns. As pointed out in the article, hedge funds had a great first half of 2008 when compared to standard benchmark indexes, outperforming Wall Street by 12%. On the other hand, given that the market lost slightly more than this on average, you could also say that hedge funds did poorly during the first six months, producing what amounted to their worst return on record. So which is it? It really depends on your perspective. Interestingly, if your mutual fund beat the market by 12%, even in a losing year, you would probably feel pretty lucky. Yet with hedge funds we expect more. We want that 30% per year, regardless of the market. After all, that is why we pay the 2-20, in good times and bad. We want returns that are uncorrelated, regardless of the market return (yes, I know, it does not always make sense).

Also of interest in the article, and something talked about before, is the pruning of hedge funds, or at least a slowdown in the net growth of new funds. The trend of the bigger getting bigger is continuing. The question is whether this will be good in the long run. As more and more pension, retirement, and endowment funds invest in hedge funds, the tendency to invest in more "stable," i.e., larger hedge funds will increase. Not only will fund-of-funds increase as institutional clients enter the industry, but this trend will produce a combination of fees upon fees, along with large diversified portfolios producing more mediocre returns. After all, a nice $500 million hedge fund can focus investments in, say, small or mid-cap banks, looking for opportunity and then taking a large position compared to totals assets. This is more difficult for the larger funds, resulting in more diversification and mediocre returns. As funds start looking and performing like mutual funds with flexibility (shorting, leverage, etc.), justifying the 2-20 may become even harder for some funds.