Reports saying hedge funds are dead could be a bit premature

Hedge fund managers are taking it on the chin of late.

Headlines describing an industry teetering on the brink and criticism about poor performance and high fees by the likes of investment legends Warren Buffett and John C. “Jack” Bogle are magnifying ill will against hedge funds from the public, politicians and labor leaders.

But industry sources said critics are painting the spectrum of 8,000-plus hedge funds with too broad a brush.

For starters, the top decile of hedge fund managers returned in excess of 20% in 2015. Further, Mercer Investment Consultants' analysis showed that hedge fund-of-funds portfolios outperformed typical 60/40 and 70/30 equity/bond portfolios in 2015 (Pensions & Investments, May 2).

When it comes to hedge fund fees, few institutional investors pay what used to be the industry standard of a 2% management fee and 20% performance fee, said Meredith Jones, partner and head of emerging manager research, Aon Hewitt Investment Consulting, Chicago.

Instead, the industry's average fees now are 1.57% and 17%, Ms. Jones said.

Negative ink recently has focused on the closure of the $1.5 billion hedge fund portfolio of the $51.2 billion New York City Employees' Retirement System on April 14 for the stated reasons of high fees and poor performance.

“I think the rhetoric about hedge funds has escalated to epic proportions,” Ms. Jones said. While there is “a kernel of truth to claims that hedge funds don't perform, are too expensive and that everyone is firing their hedge fund managers, making blanket statements is inappropriate, given the facts,” she added.

Pensions & Investments' analysis of hedge fund activity in the first four months of 2016 shows that few institutions are culling hedge funds from their portfolios (P&I, May 2).

Institutional activity in hedge funds this year through April 28 had terminations of $3.96 billion; investment of $3.56 billion in new hedge funds or hedge funds of funds; and searches for $20.32 billion, analysis of Pensions & Investments' data showed.

“Over the last few years, I think there has been a bit of a witch hunt against hedge funds to the extent that some managers are trying to rebrand themselves as something other than a hedge fund. "Hedge fund' has almost become a dirty (term),” said London-based Damien Loveday, director and global head of diversifying strategies at Willis Towers Watson PLC.

Hedge fund returns as represented by the HFRI Fund Weighted Composite index were down 1.1% in 2015, and the downdraft continued into 2016 as the index declined 0.7% in the quarter ended March 31.

The biggest driver behind the catcalling about hedge funds is the poor investment environment that's plagued all active managers for the past couple of years, said Alex Da Costa, director-hedge fund research and consulting at Pavilion Advisory Group Ltd., Montreal.

“In the first quarter, the V-shaped sell-off was followed by a sharp rebound. Hedge fund managers tend to get whipsawed in these kinds of environments,” Mr. Da Costa said, adding “it's been tough for managers with the S&P 500 trading in the 300-point range over the last two to three years.”

“Pension funds and everyone else measures the cost of hedge funds. They have to produce performance in order to justify fees,” said David A. Russell, senior investment strategist and senior consultant, at Taft-Hartley plan specialist consultant Investment Performance Services LLC, Newtown, Pa.

Like Mr. Da Costa, Mr. Russell said “hedge funds have not had a good two years, and that pulls down three- and five-year numbers,” particularly for long/short equity, merger arbitrage, commodities and many activist strategies.

By contrast, “credit funds have been killing it, and direct lending funds are turning in net high-teens performance,” Mr. Russell said.

Other sources stressed aggregate returns of the index mask returns of managers whose hedge funds produced strong performance last year.

For example, top-decile hedge funds in the HFRI index returned in excess of 20% in 2015, said Kenneth J. Heinz, president of Hedge Fund Research Inc., Chicago, which produces the HFRI family of indexes.

“The indices that get published are flawed in that most big, established firms don't participate, so accurate information about results isn't widely known,” said a hedge fund executive who spoke on condition of anonymity.

“It's about meeting expectations. If you produce the returns investors expect with the expected volatility and correlations, they are satisfied,” the executive said.

Times will be tough for hedge funds that aren't meeting investor expectations, predicted Donald A. Steinbrugge, managing partner of third-party hedge fund marketing firm Agecroft Partners LLC, Richmond, Va.

By his estimate, only 10% to 15% of the approximately 8,400 active hedge funds in the industry display “real skill.”

These managers will benefit from the wave of redemptions that Mr. Steinbrugge expects to see from managers whose hedge funds are missing their performance targets, regardless of market conditions.

While hedge fund liquidations remained low, at just 0.5% in the quarter ended March 31, according to HFR data, “a shakeout is probably a good thing,” said Willis Towers Watson's Mr. Loveday.

That's because, like Mr. Steinbrugge, Mr. Loveday believes a “relatively small proportion of the hedge fund industry (20%) represent genuine and compelling alpha. A shakeout would be OK if less attractive and skilled alpha generators drop out of the industry.”

Mr. Loveday added “it's absolutely critical that you spend the time and do the research to select the very best managers.”

With annual hedge fund attrition of 15%, Pavilion's Mr. Da Costa said occasional spikes in fund liquidations are a normal factor in the industry.

This year, Mr. Da Costa predicted the closure of some funds within the particular cadre of older hedge funds whose founders have made their personal fortunes and are ready to retire.

Pension funds are getting better at gauging hedge fund manager skill and their ability to handle rough markets, IPS' Mr. Russell said.

In fact, some of the asset owners with which he works have been reducing their core multistrategy hedge fund holdings to put “a laser focus on investing tactically. If a pension fund cut its diversified hedge fund strategies and put two to three times as much into credit funds, they would do very well right now,” Mr. Russell said.

HFR's Mr. Heinz said he's “not worried at all” about the fate of the hedge fund industry.

“This negative, anti-capitalist sentiment about hedge funds will run its course. It's a normal cyclical pattern. People are reading too much into this,” he said.

“For every hedge fund that closes, I can show you 500 hedge fund managers that are prowling the halls of the Bellagio hotel in Vegas at the SALT conference, on the lookout for investors,” Mr. Heinz said.