Santoli: Hedge funds’ pain could be your gain

Published Mon, Feb 22 20167:38 AM ESTUpdated Mon, Feb 22 20167:44 AM EST

Hedge funds are on the run. And once their footsteps quiet and the dust settles from their retreat, the markets could present more ripe investment opportunities for those who know where to look. A skein of unimpressive performances by hedge funds as a group, with frequent episodes of severe stress to many of their strategies, has sent a lot of this fast money bolting from unstable market sectors and led to investor withdrawals. The BarclayHedge index of several thousand hedge funds lost 2.8 percent in January, its worst month in nearly four years. For 2015, this index was almost precisely flat — not bad given treacherous global markets but not satisfying as a second-straight limp performance year. Prominent managers have prompted glee from the hecklers in the cheap seats by fumbling badly. Bill Ackman of Pershing Square and David Einhorn of Greenlight Capital — two stock pickers with stellar long-term records — each lost more than 20 percent in 2015. Just last week Kenneth Griffin of Citadel let go more than a dozen investment pros after the firm's main long-short funds skidded to a 6.5 percent loss in the first six weeks of the year. Late last summer much of the market instability was pressuring the "risk parity"strategies pioneered by Ray Dalio at Bridgewater Associates, which use leverage to amplify returns of "safer" assets in complex arrangements This isn't about scapegoating or mocking hedge funds, which too commonly are caricatured. They are neither the uncanny smart money nor fee-sucking trend-chasers as they're often portrayed. While lumped together into one category, they are as varied as falcons and hummingbirds. In general, hedge funds seek to deliver positive returns independent of broad market performance, by owning one set of assets against another, in exchange for about 20 percent of any gains. They generally target calendar-year, and often monthly, gains. And because they tend to have a strict risk-management discipline, when they're down they can blow out of positions quickly, sending spasms through markets. Read More The Trade: Stocks that rally on rising inflation Predictably, this latest little shakeout in hedge funds is happening not long after the Wall Street marketing machine began stamping out retail products meant to mimic an array of typical hedge-fund strategies. The Global X Guru ETF (GURU) buys stocks that hedge funds report as holdings — often months after hedge funds bought them. It had a decent run after launching in mid-2012, but is down 24 percent the past 12 months and has underperformed the S & P 500 since inception. And now, GoldmanSachs is reportedly moving to introduce an ETF with its own spin on this piggyback strategy. There are perhaps three reasons the average investor should welcome this period of struggle for hedge funds, and none has to do with bad rich guys getting their comeuppance. First, theses funds' difficulties offer some comfort that even the best-connected investors with the most expensive talent seeking an information edge have been humbled by the capricious global markets. While this doesn't fatten anyone's retirement account, it's reassuring to those who would otherwise think the game is rigged, or who seek reassurance for their choice to invest passively and cheaply in index funds. Second, hedge funds' apparent, ongoing retreat from aggressive bets should mean less potential for mini-shocks within the capital markets, eventually. Bank of America Merrill Lynch noted last week that the net exposure of hedge funds to U.S. stocks was near a three-year low. Third and most important, the pulling back of bets by fast-moving, tactical funds should leave plenty of mispriced securities behind. It's a necessary irony that just as hedge funds struggle most intensely, the climate grows ripe for the kinds of opportunistic investing they're built to exploit. This doesn't make it easy to find winners, but the environment should become richer with targets than it was in recent years, when volatility was suppressed and most assets were priced rather tightly to one another. Funds research firm Lipper points out that the valuation gap between top- and bottom-performing stocks is quite wide right now. The average forward price-earnings multiple on the 50 best-performing S & P 500 stocks is a towering 33.5, but is 12.6 on the laggard 50 stocks. Some popular hedge-fund strategies that became "crowded" have soured and could present better entry points. Owning corporate spinoffs was one of these. A quiet, consistently lucrative strategy became a bit too popular and less of a sure thing. The Guggenheim Spin-Off ETF (CSD) roughly tracks this sector, and is down 26 percent in the last year, while hedge-fund favored spins such as Ferrari's separation from Fiat Chrysler and the split of Hewlett-Packard into HP Inc. and HP Enterprise were immediate flops. The fund is becoming a basket of orphaned stocks and could be worth a look, as is a newer fund in this area, Market Vectors Global Spin-Off (SPUN) , tracking an index kept by longtime spinoff investor Murray Stahl of Horizon Kinetics. Read More Street Explained: Beware short-covering rallies There is also some juice back in fixed-income markets as the credit stress and risk aversion pulses work through them. In a world where $7 trillion in government debt has negative yields and the midtier of risky high-yield corporate bonds yield 10 percent, there would seem to be plenty to do for discerning investors hunting misvalued paper. The broad junk-bond ETFs won't sidestep most of the coming defaults, but junk-bond funds that invest more selectively could start to uncover good value, whether the Buffalo High Yield Fund (BUFHX), the Janus High Yield Fund (JAHYX) or others. Closed-end funds are a common less-trodden area hedge funds traditionally played, trading the funds against their underlying portfolios as market prices diverge from net asset value. RiverNorth Opportunites (RIV) is a new ETF from a firm that has long invested in the space, and has lots of room to operate with CEF trading near record-steep discounts. Then there's Oaktree Capital (OAK) , Howard Marks' distressed-investing firm, which not only should profit picking up wounded companies but has a valuable stake in Jeffrey Gundlach's Doubleline Capital, a bond shop that has played this market cycle skillfully. Of course, investment opportunities, like fruit, sometimes ripen on their way to turning rotten, and this market by no means has priced in dire economic or financial risks across the board. The idea that hedge funds' pain could deliver others' gain could be very, very early. And none of the above suggests that it's now a low-risk market, or a stock-picker's paradise. It won't be easy for the typical active manager to beat the indexes, even if it has become (arguably) easier. Yet, for those with fresh capital and freedom to choose one's spots, the environment is starting to surface some interesting relative values. This is especially true for investors willing to exploit their main advantage over those fancy hedge funds: the ability to ignore monthly market adjustments, buy unpopular merchandise, carry enough cash to feel comfortable, and let time and dividends do their work. And, who knows, maybe along the way someone will create an ETF of stocks that hedge funds just finished dumping? Correction: An earlier version had an incorrect ticker for the Janus High Yield Fund. It's JAHYX.

Traders work on the floor of the New York Stock Exchange.

Brendan McDermid | Reuters

Hedge funds are on the run. And once their footsteps quiet and the dust settles from their retreat, the markets could present more ripe investment opportunities for those who know where to look.

A skein of unimpressive performances by hedge funds as a group, with frequent episodes of severe stress to many of their strategies, has sent a lot of this fast money bolting from unstable market sectors and led to investor withdrawals.

The BarclayHedge index of several thousand hedge funds lost 2.8 percent in January, its worst month in nearly four years. For 2015, this index was almost precisely flat — not bad given treacherous global markets but not satisfying as a second-straight limp performance year.