According to Prequin, hedge fund gains stand at 1.15 percent in October, bringing year-to-date gains to 9.30 percent. Most in the media attribute this success to the seemingly unstoppable bull market. However, it is unwise to paint the industry’s success this year with such a broad brush, given that bull markets do not tend to favor hedge funds, particularly those employing a long/short strategy.
More importantly, the stock market’s bull run was not a 2017 phenomenon. The stock market has been on a bull run for 8 years, having celebrated its eighth birthday on March 9, 2017.
If the stock market’s bull run is to be credited with this year’s industry achievement, what happened in the intervening years from 2013 through 2016?
Rebound or Ricochet
Given the eight-year run, it is entirely appropriate to heap criticism on the hedge fund industry for being late to the party. Rather than a rebound, the present success of hedge funds is more akin to a ricochet, having bounced around for too many years absent a strategy with which to win in the bull market.
It may be entirely appropriate to credit the soaring market with hedge fund success in 2017, but only because the industry finally embraced it and evolved a strategy which benefited its investors.
The Downside
Hedge funds have been boosting investment in the stock market since the fourth quarter of 2016 at which time the industry’s net exposure was an alarming 63 percent. While no current statistics on the hedge fund industry’s current market exposure ratio could be found, the industry gains suggest the ratio has risen substantially.
If market correlation has risen to pre-financial crisis levels—or beyond, this could signal trouble. Any significant pull back in the markets would spell disaster for equity long/short funds that have chosen poorly because many hedge fund managers, faced with the pressure of out-sized gains in the S&P 500, tend to increase market exposure instead of remaining market neutral.
The Upside
If there is an upside, it lies in the fact that the market may be entering a period when fund managers have better odds of beating the overall market. Many in the industry are of the opinion that individual securities will exhibit lower correlations than they have in the past few years as compared to the years immediately following the financial crisis, which saw a broader rise in the price of stock.
Final Thoughts
The hedge fund industry is enjoying a very good year. The S&P 500 is up more than 15 percent and hedge funds, in the aggregate, are ahead more than 9 percent, the best showing for the industry in some time. Moreover, the industry is on track to set a record for assets under management for the seventh year running.
Having said all that, one must accept that what goes up will inevitably come down. Hedge fund managers need to be extremely cautious as the bull market matures. Those failing to hedge appropriately could be setting their investors up for serious losses.
