The Decline of the Original Hedge Fund Strategy
By: Kyle Tang
Tags: Economics, Economy, Finance, Investing, Hedge Funds

Today, “hedge fund” is a very broad term that covers a myriad of different fund strategies. Long/short, macro, market neutral, and event-driven are a few of the many fund strategies that are now lumped into the hedge fund umbrella.

The first hedge fund is widely regarded to have been started by Alfred Winslow Jones in 1949. Jones purchased stocks that he expected to increase in value (going long) and sold borrowed shares of stocks expected to decrease in value (going short). This long/short strategy attempts to maximize upside on long positions while limiting downside through short positions. This strategy of reducing downside risk is known as hedging, hence the term “hedge fund”.

Hedge funds remained an obscure alternative investment option until 1966 when Fortune magazine published an article highlighting hedge fund returns and their outperformance over mutual funds. This led to the opening of numerous new hedge funds, and by 1968, there were 140 operating investment partnerships that the U.S. Securities and Exchange Commission considered as hedge funds.

Over the next two decades, the hedge fund industry went through a series of booms and busts. Hedge funds began looking to other strategies and taking on more debt to leverage their investments. High leverage led to large losses and fund closures in the bear markets of 1969–1970 and 1973–1974. However, as a whole, the industry remained relatively quiet until the 1980s.

In 1986, Institutional Investor published an article about the Tiger Fund, run by Julian Robertson, which had a compounded annual return of 43% between 1980 and 1986. The hedge fund industry had once again attracted attention as now-famous hedge fund managers like Robertson and George Soros impressed high-net-worth investors and institutional investors with their outstanding returns. Throughout the rest of the 1980s and the 1990s, the hedge fund industry grew as traditional money managers transitioned into the hedge fund industry to make a name for themselves and for riches. According to data from Hedge Fund Research, from 1990 to 2001, the industry’s assets under management grew from $38.9 billion to $536.9 billion, even despite the bear markets of the late 1990s and early 2000s, which led to the closure of many prominent hedge funds, such as Robertson’s Tiger Fund.

After the 1980s, the term “hedge fund” lost some of its meaning as some so-called “hedge funds” stopped being hedged. According to the University of Amsterdam researcher Jan Fichtner’s 2013 article, “The Rise of Hedge Funds: A Story of Inequality”, macroeconomic analysis showed that hedge funds like the Tiger Fund took “massive and purely directional bets without implementing any specific hedging strategy.” Today, there are many unhedged “hedge funds” in the industry. These funds would be more appropriately called speculation funds than hedge funds.

During the 1990s and 2000s, a variety of different hedge fund strategies became more popular among fund managers and investors. Through the Tiger Fund, Julian Robertson pioneered the “global macro” strategy, which involves making investment decisions based on the interpretation of global macroeconomic trends. According to data from Hedge Fund Research, the global macro strategy made up over 60% of hedge fund investments during the early 1990s. A recent case of global macro investment activity by hedge funds was during Brexit when some macro hedge funds bet on the devaluation of the pound.

Another notable hedge fund strategy somewhat similar to the long/short model is the market-neutral approach. Due to the historical tendency of the overall stock market to go up in the long term, long/short funds traditionally run with a net long bias, having significantly more capital in long positions than short positions. Market-neutral funds are different as they carry no bias and have approximately equal long and short positions. Their goal is to deliver returns uncorrelated with the market — profiting in both upward and downward markets.

After the growth of the hedge fund industry, there are now thousands of different funds and there are many different hedge fund strategies and variations of strategies. However, as the overall industry has been growing, the original long/short strategy has been in decline by some metrics.

As per data from BarclayHedge, in 2000, the assets under management of long/short funds represented 16.4% of all assets under management (AUM) in the hedge fund industry (excluding funds of funds). In 2019, that figure was 6.1%. While the AUM of long/short funds did grow during those two decades, it only grew approximately 450%, which was greatly outpaced by the overall industry’s growth of about 1200%.

Lackluster returns may be a cause of the long/short model’s decline. Of course, there are still some long/short funds killing it with their returns. However, the average long/short fund is just not what it used to be. With increased competition due to the growth of the industry, it has become harder for the average long/short fund to find profitable investment opportunities. Especially with the rise of index investing, long/short funds are not so attractive as investors could have made higher returns by buying cheaply-managed index funds than with the average long/short fund. From 2010 to 2019, the S&P 500 total return index had an annualized return of approximately 13.6%, while the HFRI Equity Hedge Index (HFRI EHI) had an annualized return of approximately 4.7%. Over the ten years, this led the S&P 500 total return index to net a cumulative return of 257% versus the HFRI EHI’s 58%.

For three consecutive years, since 2017, long/short hedge funds have seen net outflows of assets. Also, 2019 marked the fifth consecutive year in which the overall hedge fund industry had seen more fund closures than launches. According to Hedge Fund Research, over 4000 hedge funds had closed during these five years. With larger funds usually surviving, this has led to capital in the industry becoming increasingly concentrated within mid to large-sized funds.

While it is impossible to know for certain what will happen to the long/short model — perhaps the closure of underperforming long/short funds will lead to better performance in the future by the average fund — but considering recent industry data and trends, the near-term outlook looks bleak for long/short hedge funds.