Salient to Investors:

After a decade as rock stars, hedge fund managers seem to be fading just as quickly as musicians do. Generating “alpha” is slipping further out of reach.

Goldman Sachs said in May that hedge fund performance lagged the S&P 500 index by 10 percent this year, while most fund managers still charged enormous fees. Bloomberg says that at the end of June, hedge funds had gained 1.4 percent for 2013 and have underperformed the MSCI All Country World Index for 5 of the past 7 years.

16.8 percent of hedge fund managers are women.

Traders face the immutable fact that all information has already been taken into account by the efficient market and reflected in a security’s price, so gaining an “edge” is almost impossible.

In the US, hedge funds manage a significant portion of pension funds and university endowments.

Author Sebastian Mallaby says any idiot can make a big return by taking a big risk, but what’s clever is to have a return that’s risk-adjusted.

Roger Ibbotson at Yale analyzed the performance of 8,400 hedge funds from 1995 to 2012 and found that on average they generated 2.5 percent of precious alpha, but says because of overcapacity, alphas are going to be harder to get in the future.

10,000 hedge funds manage $2.3 trillion. Most charge a management fee of 2 percent of assets plus 20 percent of the profit generated at the end of the year.

A typical hedge fund life cycle has 4 evolutionary stages:

Stage 1. The funds’ managers are hungry, motivated, and often humble enough to know what they don’t know – the best time to put money in, but also the hardest, as the funds tend to be very small.
Stage 2. The fund has achieved some success, and the managers not yet so well-known that the fund is too big or impossible to get into.
Stage 3. The fund gets “hot” and attracts investors drawn to flashy success stories.
Stage 4. The fund manager is seen as a bidder for baseball teams or zillion-dollar Hamptons mansions. Most funds stop generating the returns they once did by this stage, as the manager becomes overconfident and the fund too large.

Jim Liew at NYU says the bigger a fund gets, the more difficult it gets to maintain strong performance because the number of opportunities is limited in terms of putting that much money to work.

Most of the advantages hedge funds investors once had have evaporated. Supercharged computer trading means speed is one of the few ways left to gain an advantage.

Hedge funds provided huge demand for the toxic mortgage derivatives that helped lead to the financial collapse of 2008. The financial security of untold numbers of retirees could be threatened by a full-scale hedge fund meltdown, though that possibility seems remote.

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