Swedroe: Hedge Funds Grow, Returns Fall

May 09, 2016

Reasons For Falling Performance
First, the early successes of hedge funds (when the industry was young and small) attracted more dollars. However, the opportunities to generate excess returns haven’t kept pace with increased AUM. In other words, the “trades” that hedge funds pursue became “crowded,” and the mispricings they were previously able to exploit either shrank or disappeared altogether.

Second, at the same time the supply of capital was increasing, the supply of victims that hedge funds need to exploit in order to generate excess returns (alpha) has been falling—the supply of sheep waiting to be sheared has been shrinking.

As pointed out in my book, “The Incredible Shrinking Alpha,” which I co-authored with Andrew Berkin, the percentage of stocks owned directly by retail investors (considered dumb money) has fallen from about 90% 70 years ago to about 20% today.

And there’s yet a third explanation for the deteriorating performance. The level of competition has increased as today’s institutional money managers are much more highly skilled.

Charles Ellis, who is highly respected in the investment industry, noted: “Over the past 50 years, increasing numbers of highly talented young investment professionals have entered the competition. . . . They have more-advanced training than their predecessors, better analytical tools, and faster access to more information.”

Legendary (or once-legendary) hedge funds such as Renaissance Technologies, SAC Capital Advisors and D.E. Shaw hire Ph.D. scientists, mathematicians and computer scientists. MBAs from top schools, such as the University of Chicago, Wharton and MIT, flock to investment management armed with powerful computers and massive databases. This leads to what is known as the paradox of skill—the tougher the competition, the harder it is to generate performance that distinguishes you from the crowd.

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