It can’t be sugarcoated. Hedge funds, for the third year running, have concluded another inauspicious year, not only in terms of gains, but also in the context of asset flows and industry growth.

Glaring Failures

Not to paint the industry with too broad a brush, it is important to begin by saying that the majority of hedge funds either were even, or had positive gains for 2016. It should also be noted that although 61 percent of hedge funds experienced redemptions, a significant percentage of these redeemed funds were reinvested with higher performing hedge funds. Lastly, while it is fact that hedge fund closures outpaced hedge fund starts for the first time since the financial crisis, the difference between starts and closures was not a large number.

However, looking at the industry as a whole, hedge funds underperformed the S&P 500, had net negative asset flows and closed more shops than they opened.

Does This Suggest an Industry in Decline?

Probably not, but it very well may signal a tipping point. It is time for the hedge fund industry to respond. Those hedge funds experiencing two or three years of break-even performance or worse will almost certainly be punished by investors.

Redemptions from underperforming funds will continue until these funds either turn around, or are driven out of business. This is not to say that overall hedge fund assets under management (AUM) will decline, although they may. Rather, it is more likely that funds redeemed from underperforming firms will shift to higher performing firms or firms with superior strategies. This will necessarily result in a shrinking number of hedge fund firms going forward. This is not necessarily a bad outcome.

What Is the Solution?

Too many hedge funds have lost sight of their core objective…preserve capital. In short, too many hedge funds don’t hedge. While there are many hedge fund managers that excel at picking stock or identifying cryptic correlation trades, too few are skilled at constructing balanced portfolios, true hedging and managing multifaceted risks.

Portfolio managers that have made fortunes on fundamental, momentum-based trading are now focusing on neutral long and neutral short strategies and quant funds, are investing capital to create a hybrid investment style.

What about Jobs?

These shifts in investment styles will create challenges for hedge funds—challenges that are not easily met with existing talent. As a result, hedge funds will likely step up the hiring of asset management talent with proven portfolio construction talent. Also in demand will be quant-equity and quant macro researchers. Demand for developers is also likely to increase.

In short, the prospects for employment in the hedge fund industry are promising, given the right experience and educational background. The hedge fund industry need only fear decline if hedge fund management fails to rise to today’s challenges.

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It appears that the hedge fund industry, on average, will end 2016 on the wrong side of the S&P 500, the arbitrary benchmark, which in the eyes of many, heralds a successful level of performance. The S&P 500 is up some 10.5 percent year-to-date, while average aggregate hedge fund gains hover around 4.5 percent.

Another Year of Mediocrity

One can debate the merits of using the S&P 500 as a benchmark for hedge fund performance, but no matter how persuasive the argument, the fact is that many hedge fund firms are disappointing their investors. This is irrefutable, borne out by -$77 billion in net outflows through October 2016. This is the first time in recent memory that, taken together, hedge funds will experience negative annual growth in assets under management. Another unpleasant fact is that hedge fund closures have outpaced hedge fund starts in 2016.

Investor Backlash

After eight consecutive years of underperforming any number of broad market indices, investors are saying, enough is enough. Major insurers such as MetLife and AIG cut back their hedge fund investments in a substantial way. Public pension funds also expressed their dissatisfaction with massive redemptions. Underperformance wasn’t the only issue that irked insurers, public pension funds and other investors; it was that they were paying excessively for the privilege. Hedge fund fees have always drawn fierce criticism, but the combination of high fees, poor returns and/or losses, became a burden too heavy to bear for a significant swath of investors.

Winners and Losers

In all human endeavors, there are winners and losers. The hedge fund industry is no exception. Average returns in the industry are lackluster, but some hedge funds that have managed to exceed the S&P 500’s gains by two, three, and fourfold. For example, Cheyne Capital’s Total Return Credit Fund was up almost 43 percent for the year through October. It is reported that at least one-half of more than 11,000 hedge funds are in positive territory, if not up to the gains enjoyed by the S&P 500.

Hedge fund investment is not a spectator sport. The Chicago Cubs enjoyed a fan base that remained loyal to the franchise for generations. These fans were finally rewarded with a World Series victory after 108 years. Unlike Cubs fans, investors expect hedge funds, and their managers to produce wins each year.

It is realistic to speculate that the number of hedge funds will continue to decline if poor performance continues to be coupled with high fees.

Hedge Fund Jobs

The shrinking numbers of hedge fund firms do not necessarily signal a shortage of hedge fund jobs. While it is true that a percentage of this capital has fled the hedge fund industry for other opportunities, much of it has been reinvested into higher performing firms. As these firms swell their assets under management, they will likely be reaching out for the talent necessary to meet their obligations to their investors. Rather than despair, recognize that this is capitalism at its best. In a capitalistic economy, only the strongest performers survive and survive they will. So hone your skills, improve your network and redouble your job seeking efforts.

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Should I Stay Or Should I Go?

November 29, 2016

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Little Rhode Island Delivers Devastating Blow to Hedge Funds

October 31, 2016

According to a recent article published in FINtech, the Rhode Island State Investment Commission has announced its decision to redeem $534 billion invested in seven hedge funds. This enormous sum does not include the $51 billion it plans to redeem from Viking Global. This reduces Rhode Island’s exposure in Viking Global by 50 percent and […]

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Hedge Funds See a Looming Obstacle in the Gains Battle

October 3, 2016

Having struggled with an indecisive and opaque Federal Open Market Committee, chaired by the enigmatic Janet Yellen since February 2014, hedge funds and the broader investment community must now consider the possibility that the Fed’s purchasing options may one day expand beyond U.S. Treasuries and agency securities. The Interest Rate Debacle Equity markets have plundered […]

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