Hedge funds no longer need the star system to thrive

New York

HEDGE funds' brightest lights have fallen on hard times, but don't shed a tear for the industry just yet.

The list of once-revered-now-humbled hedge fund managers is growing. Alan Fournier is shutting Pennant Capital Management after nearly two decades, acknowledging that "recent returns have been disappointing".

David Einhorn's main hedge fund at Greenlight Capital was down 14 per cent in the first quarter after a decline of 4.1 per cent annually from 2015 to 2017. Pershing Square Capital Management's Bill Ackman called his recent returns "particularly unsatisfactory", and investors apparently agree. Mr Ackman's assets under management shrank to US$8.2 billion as of March from US$18.3 billion in 2015.

Despite the travails of star managers, however, the hedge fund industry is doing fine. The HFRI Fund Weighted Composite Index returned 0.3 per cent during the first quarter, compared with a negative 0.8 per cent for the S&P 500 Index, including dividends. Granted, hedge funds haven't kept pace with the stock market in recent years, but they've fared better than many of the stars among them. The HFRI index has returned 4 per cent annually from 2015 through March, compared with 10.2 per cent for the S&P 500.

More important, the industry has retained its faithful following. Investors poured a net US$284 billion into hedge funds from 2010 to 2017, according to HFR, and total assets were at a record US$3.2 trillion as of the end of 2017. Still, the recent stumbles of the industry's most celebrated managers are a turning point that hedgies should heed. Mutual funds have been through this, and their experience is instructive.

Like hedge funds, the mutual fund industry was once dominated by star managers. Investors worshipped stock and bond pickers such as Peter Lynch, Bill Miller and Bill Gross for obvious reasons - and paid them accordingly. Under Mr Lynch, Fidelity's Magellan Fund returned 29.1 per cent annually from May 1977 to May 1990, besting the S&P 500 by an astonishing 13.4 percentage points a year. Mr Miller's Legg Mason Value Trust beat the S&P 500 for 15 consecutive years from 1991 to 2005, outpacing the index by 4.9 percentage points annually during that period. And bond manager Mr Gross beat the Bloomberg Barclays US Aggregate Bond Index by one percentage point annually during his 27 years as manager of the Pimco Total Return Fund - a huge margin of victory for a bond manager.

But the market eventually turns on most managers. Sure, a few like Mr Lynch manage to walk away before then. Most, however, will encounter periods when their style of investing simply isn't working. It happened to Mr Miller and Mr Gross. After Mr Miller's 15-year win streak, his Value Trust returned a negative 5.1 per cent annually from January 2006 until his tenure ended in April 2012, while the S&P 500 returned 4 per cent a year. And Mr Gross has struggled to recreate his old magic. His Janus Henderson Global Unconstrained Bond Fund has lagged the aggregate bond index by 0.2 percentage points annually since he took the reins in September 2014 through March.

Over time, it has become increasingly clear to investors that even the best mutual fund managers aren't gods but merely artisans plying their investment strategies. Mr Miller's strategy was value - buying cheap stocks. Mr Lynch's was a combination of quality and value - buying highly profitable and well-capitalised companies for a reasonable price. Those strategies work great, until they don't.

Which raises inevitable questions: Are fund managers overpaid, and are there ways to execute their strategies more cheaply?  The answer to both is yes. There's a new generation of so-called smart beta mutual funds and exchange-traded funds (ETFs) that replicate investing styles used by Mr Lynch, Mr Miller, Mr Gross and others. They're cheaper, more transparent and increasingly popular with investors. Smart beta ETFs have taken in US$319 billion since 2013 through Tuesday, compared with just US$128 billion from 2006 to 2012, according to Bloomberg Intelligence.

Investors will soon ask similar questions about hedge funds. There are already several dozen ETFs that replicate hedge fund strategies. It's early days, but more will undoubtedly follow, and they'll become better and cheaper with time.

Like mutual fund managers, hedgies aren't going away any time soon. But the cult of star hedge fund managers is dying, and the opacity and high cost of hedge funds will follow. BLOOMBERG

• This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
  The writer is a Bloomberg Gadfly columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young