Why Do Hedge Funds Continue to Under Perform?

This is a top-of-mind question for institutional investors and the answers are as varied as the hedge fund industry. Obviously, the answers offered can’t all be accurate. Furthermore, answers will necessarily differ from one fund strategy to another.

Morgan Stanley conducted a survey at a recent conference of long/short fundamental equity hedge funds. Morgan Stanley’s equity strategist, Adam Parker, wrote in a recent article that the top three reasons proffered for the poor performance experienced by long/short equity funds were; 1) crowding, 2) factor exposure and 3) stock selection, in that order.

Are These Defensible Responses?

Crowding, by definition, is the scenario in which too many dollars are chasing the same trade. While this may be true, it smacks of ‘group-think’ and, one likes to think of hedge funds and their managers as independent, innovative thinkers.

Factor exposure, as we know, suggests that acknowledged risk, in the face of a specific event, was underestimated. This is a less than flattering admission to make. Investors have been promised a greater degree of competence than this response implies.

Stock selection is largely self-explanatory. It is a blanket acknowledgement that firms selected poorly performing stock. Although third on the list, it is perhaps the most accurate answer of any given for the long/short fundamental strategy.

Some Soul-Searching Is Required

Crowding and factor exposure are really two sides of the same coin. That coin, in the case of a long/short fundamental strategy is stock picking; yet, it was number three on the list of responses as dead last.

Is it possible that there are just too many dollars invested in too few stocks or, is it possible there are more hedge fund firms than the market will bear? Blackstone’s president, Tony James believes the hedge fund industry’s assets under management will shrink by as much as 25 percent in the coming year. James attributes this to performance.


The hedge fund industry needs to get its head around the problem and correct it. The critical element is defining the problem. Is it, in fact crowding? Is it factor exposure? Is it stock selection? Or, is it something else entirely?

Many argue that ISIS can’t be defeated because the threat isn’t being appropriately identified. The same may be true with hedge funds. Under performance can’t be turned around until the cause has been clearly and accurately defined. If hedge funds practicing a long/short fundamental strategy define crowding as the number one reason for under performance, Mr James may be proven right.

Hedge Fund Jobs Are at Stake

Clearly, assets under management will not shrink at hedge fund firms that are delivering alpha returns. The funds at risk are those delivering beta…or worse. Moreover, there is no certainty that assets would flee hedge funds. The more likely scenario is that hedge invested funds would flee beta for alpha.

As a result, the prospects for hedge fund employment remain relatively static, although it must be acknowledged that diminished prospects are more probable than enhanced ones. That said, opportunity’s knock smiles more favorably on those prepared to answer the door.

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